Panadagan Vacuums Limited (PVL) is a worldwide leader in the manufacturing of industrial vacuums. The company is located in Thorold, Ontario. PVL sells vacuums to distributors in North America, Europe, and Asia. Over the last 10 years, PVL has seen its sales and market share deteriorate due to foreign competition. While PVL is considered a leader in product development and quality, the company has been unable to secure large contracts due to its higher-than-average selling prices. Management attributes this to the high cost of labour in Canada. 

PVL has two divisions—the vacuum-assembly division and the components-production division. Currently, PVL manufactures seven standard industrialvacuum models in its vacuum-assembly division. This division also manufactures special order models for its customers when its standard models are unsuitable. The vacuum-assembly division also has a service department that repairs vacuums under warranty or, when the warranty has expired, for a service fee. PVL’s distributors also provide warranty service on PVL’s behalf. PVL’s component production division currently produces about 60 percent of the components used in the manufacturing of its vacuums. The other 40 percent is purchased from external suppliers by the vacuum-assembly division. Components are sold from the components-production division to the vacuum-assembly division using a negotiated transfer price, which approximates market value. 

Recently, PVL was approached by a Korean manufacturing company, Engine Tech Limited (ETL). ETL specializes in manufacturing small engines. ETL has proposed an arrangement whereby it would produce engine model P12, which PVL currently uses in two of its standard vacuum models. PVL currently produces these engines in its components division. ETL has agreed to provide P12 engines for a fiveyear period at a cost of 130,000 Korean won per unit. At current exchange rates, this would amount to $2,200 Canadian per unit. Duty and freight would cost approximately $300 Canadian per unit for a total of $2,500 Canadian per unit. PVL would agree to purchase a minimum of 5,000 units per year during the five-year term of the contract. If PVL failed to purchase the minimum amount, it would be required to pay a penalty of 30,000 Korean won (currently $500 Canadian) per unit of shortfall from the minimum. This penalty payment would be due at the end of the year in which the shortfall occurs. 

PVL is considering modifying two of its existing models so that they use the P12 engine. The Model 3 unit could be modified to use the P12 engine instead of its existing engine, the P10, which is a less powerful engine than the P12. If this occurs, the cost of the engine to the vacuumassembly division would increase by $1,000 per unit. All other costs would remain the same. Annual sales of the Model 3 would be expected to rise by 20 percent if this modification was made. PVL is also considering modifying the Model 4A to use the P12 engine instead of its existing engine, the P14, which is a more powerful engine than the P12. If this occurs, the cost of the engine to the vacuum-assembly division would decrease by $1,000 per unit. All other costs would remain the same. Annual sales of the Model 4A would be expected to decrease by 20 percent if this modification was made. 

You are the assistant controller of PVL. The controller of PVL has asked you to prepare a report to her on whether the offer from ETL should be accepted. She would also like you to discuss whether the P12 engine should be used in Models 3 and 4A. To assist you in your analysis, she has asked the accounting and marketing departments of the vacuumassembly division to prepare information on expected sales and costs for the seven standard models that PVL produces (Exhibit 9A-1). This information represents management’s best estimate of average selling prices and costs for the five-year term of the contract proposed by ETL. Costs and selling prices are not expected to change substantially over the five-year term of the contract. The controller has also had the accounting department of the component production division provide you with the expected costs of producing the P12 engine (Exhibit 9A-2). These costs are not expected to change substantially over the five-year term of the proposed contract with ETL either. The controller has instructed you to provide a quantitative analysis of the decisions in your report. She would also like your report to address the qualitative aspects of these decisions. 

Required Prepare the report requested by the controller. 

Estimated sales volumes were prepared by the marketing department of PVL. Historically, the marketing department’s estimates have been reasonably accurate.

Divisional overhead has been applied at a rate of 20 percent of direct labour. Divisional overhead includes purchasing costs, management salaries, rent, utilities, warranty service costs, and administrative costs.

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Exhibit 9A-1 Panadagan Vacuums Limited Information on Standard Models Engine Model Selling Price Estimated (1) Annual Sales Volume (units) Engine Source Model Used External $20,000 4,000 P10 vendor Components division $25,000 2,000 ЗА P12 Components division $40,000 2,000 4 P12 External vendor $50,000 1,500 4A P14 External $70,000 500 P16 Components division $80,000 500 S4 Components division $95,000 200 S8 3. Current Production Costs (in dollars) Model 3 ЗА 4 4A 5 Labour $5,000 $7,000 $11,000 $15,000 $20,000 $25,000 $30,000 Divisional 1,000 1,400 2,200 3,000 4,000 5,000 6,000 Overhead (1) Components Engine Housing 3,000 4,000 4,000 5,000 7,000 10,000 15,000 2,000 2,500 3,000 3,500 4,000 6,000 7,000 Other 6,000 6,100 9,000 18,400 20,200 20,200 28,000 Total Cost $17.000 $21.000 $29.200 $44.900 $55.200 $66.200 $86.000