You are an accounting consultant with Numbers-R-Us LLP, a firm of independent accounting and management consultants. You have been asked
You are an accounting consultant with Numbers-R-Us LLP, a firm of independent accounting and management consultants. You have been asked by one of your clients – Mr. Joe Farrell, the president of Farrell Industries (Farrell Ind.) in Brampton, Ont. – for some advice. Note: Mr. Farrell has a solid accounting background but relies on your professional judgment.
Farrell Ind. manufactures 750,000 axles a year. These axles are metal parts that are used in making gear levers; one axle is included in each lever. Farrell Ind. uses these axles to make the levers it sells to customers across Canada.
Farrell Ind. has been approached by Robert Miller, the president of Miller Axles Corp., a manufacturer of axles. Mr. Miller has offered to sell axles to Farrell Ind. for $10 each (including the shipping costs). Miller could ship the axles to Farrell Ind. within one week of the order and offers a two-year warranty on each axle. Mr. Miller has guaranteed the price for two years.
Currently, Farrell makes the axles in a specially-designed area in its factory in Orillia. Each axle costs $14 to make (see the summary at the end of this document). Mr. Farrell wants you to recommend whether Farrell Ind. should buy the axles from Miller or continue to make the axles themselves.
You gathered the following information in your research. Some of the data may be useful in your decision; some may be irrelevant.
- Farrell Ind. sells its levers at prices between $65 and $75 each. Farrell’s main competitors charge between $45 and $55. Farrell Ind. can charge higher prices because it offers the highest-quality levers, a five-year warranty, and delivery within two days of the order.
- Farrell Ind. currently sells 750,000 levers a year. Farrell’s profit on each lever is $20.
- In response to its customers’ requests, Farrell Ind. designs several new models of levers each year. Each new lever design requires some modifications in the axles. Miller can make these design changes at no cost if it is given one month’s notice.
- Axles are large, and take up a lot of storage room. Therefore, Farrell Ind. makes axles in small batches as they are needed.
- If Farrell Ind. buys levers from Miller, the factory space used to make axles will not be used. Farrell Ind. can save about $50,000 a year in heating and electricity costs if it shuts down this part of the factory; total heating and lighting costs for the entire factory average $300,000 a year.
- If Farrell Ind. buys the levers, it will lay off the six long-time employees responsible for making the axles, each of whom earns $50,000 annually. The one-time severance cost will be $120,000.
Mr. Farrell does not believe that any other labor costs will change.
- The machinery used by Farrell Ind. to make axles was bought in 2010 for $1,500,000. It has an expected useful life of 15 years, with no disposal value after that. Mr. Farrell believes he can sell the machinery to another lever manufacturer; the net proceeds would be $150,000.
- Miller Axle Corp. is well-known for making better-than-average axles in large quantities. It has been in business for 20 years.
TABLE 1: COST OF MAKING KRONKS
Direct labor $6.75
Direct material 5.25
Overhead allocated* 2.00
THE TOTAL UNIT COST IS $14.00
*Includes all factory and administrative overhead.
- Use appropriate analysis tools
- Qualitative analysis for alternatives available
- Establish which cash flows are relevant for this decision
- Calculate ROI payback periods for each alternative
- Reach a decision for this business, providing justification for the best alternative