Rick Morgan sat at his desk mulling over an important decision. As plant manager for the Salina factory, he was under pressure to reduce costs and improve productivity. He had been approached several weeks before by Lauren Gosnell, the purchasing manager, who told him that a major supplier had offered to supply the plant with Component A56 at a delivered cost that was less than the factory’s full cost to manufacture the component.
Rick was well aware that good deals are sometimes not as good as they sound. So, he had asked Lauren and James Terrant, the plant controller, to prepare full cost analyses of the offer. The results lay on his desk. Lauren’s report was brief and to the point. The factory used 50,000 units of Part A56 each year. The full manufacturing cost was $45 each; the proposed price from the supplier was $39 each. This would result in a $300,000 per year cost savings. Lauren was wholeheartedly in favor of outsourcing this component.
James’s report was also brief. He detailed the direct materials, direct labor, and overhead assigned to Part A56. His analysis supported Lauren’s assertion that the full cost of the component was $45 each. James also recommended outsourcing.
While both reports were in favor of outside purchase, Rick was troubled. He wondered if there were hidden costs of outsourcing. He also wondered about the internal costs—and what would happen to the employees who worked on the A56 line. Were there any costs associated with the layoffs that had not been considered? Rick picked up the phone and called his former business professor, Kate Buchanan, and asked her to meet him for lunch the next day.
RICK: Kate, you’ve had a chance to read these two reports. Tell me, does it seem that anything is missing? Is this as great a deal as it sounds?”
KATE: Well, on the surface, Rick, it certainly looks good. But you may be right— there are some missing factors. For one thing, the outsourcing of this component will lead to the idling of one of your production lines. What are you planning to do with the excess capacity? Are there some costs hidden in overhead that will continue even though you aren’t making the part anymore?
RICK: What do you mean by hidden?
KATE: I mean that some costs are flexible, but others are committed. Basically, flexible costs disappear immediately when you stop making a part—like direct materials.
If you don’t make A56, then you don’t need to buy the sheet metal and solder.
However, other costs are committed. For example, you use welding equipment on that line, what will happen to it? Right now, depreciation on the equipment is included in the overhead assigned to A56. When you stop making the part, will you still have the welding equipment? If so, the depreciation will still be there, but will be spread over other items you manufacture. I think you are right to consider the impact of the layoff, too. We often think of direct labor as being a variable or flexible cost. But any worker layed off will file for unemployment insurance. Your rates on all your remaining workers will skyrocket and will stay high for the next three years.
And that is assuming no further layoffs. Plus, there’s more.
RICK: More? How so?
KATE: Remember activity-based costing from our accounting class? Your plant clearly uses a functional-based approach to assigning overhead. If it used activity based costing, you might find out that purchasing and receiving costs will go up if the supplier’s offer is accepted. Of course, there could also be a decrease in that the materials used now would no longer be purchased, received, and stored.
RICK: Wow, Kate, how am I going to get all the information I need? I’m afraid I can’t just ask James. He’s been here forever. I tried to get him to look into ABC a year or so ago. He won’t—says it’s a fad that isn’t worth the trouble. And Lauren is really enthusiastic about this possibility. I won’t be getting an objective assessment from her. Would you like to take this on as a project? I’ll pay your consulting rate.
KATE: (shaking her head) I sympathize, Rick. Unfortunately, it looks as if you might have to start making some tough decisions—starting with the Accounting Department.
If James can’t do an appropriate analysis of this one opportunity, he won’t be able to meet your needs for information in the future. I think you need more than a one-time analysis. You need ongoing managerial accounting help. I can recommend a couple of recent accounting grads. One in particular has over 10 years of experience in industry and an outstanding academic record in our graduate program. He’s intelligent, flexible, and energetic.
RICK: You may be right. Could you e-mail me his name and phone number when you get back to the office? I’d like to consider this. Meanwhile, let’s grab a second cup of coffee and you can bring me up to speed on this flexible versus committed costing idea.
Form groups of three to five students to discuss the following questions. Choose one representative from your group to present the group’s answers to the class.
1. Suggest some costing features that a controller should consider in evaluating the outsourcing opportunity. How would you go about getting the appropriate information?
2. Why do you think Lauren is so enthusiastic about the outsourcing opportunity? Could there be any reason(s) other than cost savings?
3. Rick is clearly considering a change in the controller. Do you think he should fire James? Where should Rick’s loyalties lie?