Milan DiElectrics (MDE), an Italian firm founded by Frank and Florence Potestio 25 years ago, produces a unique class of ruggedized capacitors for military, aerospace, and industrial applications. Ruggedized solid-state components must be able to withstand extreme temperatures and vibration. The Potestios built MDE into a multimillion-euro firm before they sold it last year to BTX, a large Dutch conglomerate. The Potestios agreed to stay with MDE for one year to ensure the smooth integration of MDE into BTX. The sale agreement between the Potestios and BTX set aside a significant portion of the purchase price for MDE that would be paid out to Frank and Florence if certain net income targets were achieved in the year following the sale. The higher the reported income of MDE, the more of the set-aside Frank and Florence receive. The contract specified that generally accepted accounting procedures (including MDE's existing absorption costing system) would be used to calculate MDE's net income for determining the amount of the set-aside returned to the Potestios.
MDE's existing absorption costing system allocates fixed manufacturing overhead to units produced, using the number of capacitors produced. While MDE produces several different models of capacitors with different electrical specifications, there are negligible differences in the variable costs and manufacturing facility resource demands of the various models. So volume is measured in terms of capacitors produced. MDE incurs annual fixed manufacturing overhead of €30 million. Because of the scarcity of certain precious metals and the limited supply of highly skilled technicians to achieve the demanding standards required of MDE capacitors, MDE faces the following variable cost per unit schedule:
Quantity Manufactured _____________________ Variable Cost
Per Year (000s) ..................................... Per Unit (euros)
300 ....................................................... 50.0000
350 ....................................................... 54.2857
400 ....................................................... 60.0000
450 ....................................................... 73.3333
500 ....................................................... 90.0000
All MDE capacitors sell for €200. Based on detailed conversations with their customers, Frank and Florence are highly certain they will sell 300,000 capacitors this year and for the next several years. However, this is private information known only to the Potestios and not to BTX. The sale agreement does not specify any inventory holding costs or any penalties for excessive ending inventories.
Assume that MDE had no beginning inventories and the only costs (expenses) MDE incurs are the fixed and variable manufacturing costs described earlier.
Required:
a. Given the information provided, how many capacitors do you expect the Potestios will produce this year? Justify your answer with clearly labeled numerical calculations and a short essay explaining how you arrived at your conclusion. 474 Chapter 10
b. Assume that the managers of BTX have all the private knowledge held by the Potestios, the BTX managers are in control of MDE, and the BTX managers want to maximize the net cash flows of MDE. What production level will the BTX managers choose? (Assume it is costly to hold inventory and there is no uncertainty regarding expected capacitor sales.) Justify your answer with clearly labeled numerical calculations and a short essay explaining how you arrived at your conclusion.
c. Before starting the current fiscal year, the Potestios are approached by another electronics manufacturing and testing company, ADZ, that proposes the following outsourcing arrangement between ADZ and MDE. ADZ will provide the final manufacturing steps in producing MDE capacitors, testing the completed units, packaging, and shipping them to MDE customers. MDE will pay ADZ € 90 per capacitor manufactured. This will allow MDE to reduce its fixed manufacturing cost by € 25 million annually, and MDE can reduce its variable manufacturing cost by €10 per capacitor. ADZ is a very high-quality firm, and so the Potestios and BTX have no concerns about the impact of outsourcing some of the manufacturing processes and testing to ADZ. Do you expect the Potestios to accept the ADZ outsourcing proposal? Assume selling price and expected sales do not change if MDE accepts the ADZ proposal. Justify your answer with clearly labeled numerical calculations and a short essay explaining how you arrived at your conclusion.
d. Assume that the managers of BTX have all the private knowledge held by the Potestios, the BTX managers are in control of MDE, and the BTX managers want to maximize the net cash flows of MDE, do you expect the BTX managers to accept the ADZ outsourcing proposal? Justify your answer with clearly labeled numerical calculations and a short essay explaining how you arrived at your conclusion.
e. Explain why your answers to parts (c) and (d ) either are the same or different.