The Tan Corporation uses multi colour moulding to make plastic lamps. The moulding operation has a capacity of 200,000 units per year. The demand for lamps is very strong. Tan will be able to sell whatever output quantities it can produce at $40 per lamp.
Tan can start only 200,000 units into production in the Moulding department because of capacity constraints on the moulding machines. If a defective unit is produced at the moulding operation, it must be scrapped at a net disposal value of zero. Of the 200,000 units started at the moulding operation, 30,000 defective units (15%) are produced. The cost of a defective unit, based on total (fixed and variable) manufacturing costs incurred up to the moulding operation, equals $25 per unit, as follows:
Direct materials (variable)............ $16 per unit
Direct manufacturing labour, setup labour, and materials-handling labour (variable)....... .......... 3 per unit
Equipment, rent, and other allocated overhead, including
inspection and testing costs on scrapped parts (fixed).. 6 per unit
Total...................... $25 per unit
Tan’s designers have determined that adding a different type of material to the existing direct materials would result in no defective units being produced, but it would increase the variable costs by $4 per lamp in the Moulding department.
REQUIRED
1. Should Tan use the new material? Show your calculations.
2. What nonfinancial and qualitative factors should Tan consider in making the decision?