MIDDLE EAST TECHNICAL UNIVERSITY

IE 248 - ENGINEERING ECONOMY & COST ANALYSIS I

CASE
STUDY

Burcu YÜZÜAK
Onur YILMAZ

Instructor:
İSMAİL SERDAR BAKAL

June 2010, Ankara

Question 1:
Capacity Usage (# Unit 3)
Total Capacity 7500 hours
Total Number of Batches (7500 / 3) 2500
Total Number of Garments (2500 * 100 ) 250.000

Partial Income Statement (Stonewash Finish)

Revenues (250000 * $2) $500.000

Costs Cost Hierarchy

Indirect Costs
Product Sustaining Costs Product Sustaining $140.000
Utility Expense ($15 per machining hour* Output Level $112.500
7500 hours)
Setup Cost ($25 per batch * 2500 batches) Batch Level $62.500
Material Handling Costs ($ 0.1 / garment * Output Level $25.000
250000 garments)
Total Indirect Costs $340.000

Direct Costs
Disposable Supplies ($0.09 / garment * Output Level $22.500
250000 garments)
Shipping Costs ($ 0.1 / garment * 250000 Output Level $25.000
garments)
Total Direct Costs $47.500

Total Costs $387.500

Operating Income $112.500

Total Profit per Garment $0,45

As calculated above, total profit per garment is $ 0,45 when only Stonewash Finishing
is used for the all available machine capacity.

Question 2:

In the second part, it is assumed that change-over costs are batch level costs.

Since shipments are arriving on separate days, each time the shipment arrives; the
company should retool the machine for New Specialty finish and then retool back to
Stonewash finishing because of the excess demand for the Stonewash finishing.

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 Usage of Capacity
Total Capacity 7500 Total Numbers of Garments - SF
Total Shipments 100 Available Hours 5400
Total Number of Retools (100 *2) 200 Hours Allocated for Each Batch 3
Total Loss from Retools (200 * 3) 600 Number of Batches (5400/3) 1800
Number of Garments (1800 * 180.000
Available hours for finishing 6900 100)
Total Anticipated Number of Garments 50.000
(500 * 100) Total Numbers of Garments - NSF
Total Number of Batches 500 Available Hours 1500
(50000/100) Hours Allocated for Each Batch 3
Total hours Allocated for NSF 1500 Number of Batches (1500/3) 500
(3 hours/ batch* 500 batches)
Number of Garments (500 * 50.000
Total Hours Available for SF 5400 100)

Costs for Stonewash Finish

Activity Cost Hierarchy per Unit of Cost # of Units of Cost Total
Category Allocation Base Allocation Base
Direct Costs
Disposable Supplies Output unit-level $0,09 180000 (Output) $16.200
Shipping Output unit-level $0,10 180000 (Output) $18.000
Indirect Costs
Product Sustaining Product Sustaining $140.000
Costs
Material Handling Output unit-level $0,10 180000 (Output) $18.000
Set-up Costs Batch Level $25 1800 (Batches) $45.000
Utility Expenses Output unit-level $15 5400 (Machining $81.000
Hours)
Change Over Costs Batch Level
Salary of Workers $200
($25 /hour * 4 hours * 2 workers)
Disposable Supplies Expense $50
Total costs for one Change Over $250
Total costs for change-overs (250*200) $50.000
Overhead Allocation Rate for Change-Overs $21,74
($50000/2300)
$21,74 1800 (Batches) $39.139,43
Total Costs $357.339,43
Cost per Unit (Total Cost / 180000) $1,985219
Profit per Unit (Selling price - Cost $0,015
per Unit)

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Costs for New Specialty Finish
Activity Cost Hierarchy per Unit of Cost # of Units of Cost Total
Category Allocation Base Allocation Base Allocated
Direct Costs
Disposable Supplies Output unit-level $0,90 50000 (Output) $45.000
Shipping Output unit-level $0,20 50000 (Output) $10.000

Indirect Costs
Product Sustaining Costs Product Sustaining $37.500
Material Handling Output unit-level $0,10 50000 (Output) $5.000
Set-up Costs Batch Level $25 500 (Batches) $12.500
Utility Expenses Output unit-level $15 1500 (Machining Hour) $22.500
Change Over Costs Batch Level $21,74 500 (Batches) $10.869,57
Total Costs $143.369,57
Cost per Unit (Total Cost / 50000) $2,8674
Profit per Unit (Selling price - Cost per Unit) $4,132609

When new contract is undertaken, as calculated in the tables above, profits per unit for
New Specialty finish and Stonewash finish are $0,015 and $4,132609 respectively. In these
calculations total machine capacity is allocated between these two finishing activities with the
limitations given in the question. Furthermore, number of garments related to Stonewash
finishing is calculated by using the rest of the machine hours left after allocation of New
Specialty finish.

Question 3:

Now we are assuming that change-over costs are one of the product sustaining costs.
Since, product sustaining costs are calculated regardless of number of units completed or level
of batches we can consider some allocation possibilities. First option could be that all change-
over costs are allocated to Stonewash Finish and New Specialty Finish equally. Because, for
every shipment, the company first retools the machine for New Specialty then retools back for
Stonewash and moreover for each retool same amount of time is used. Second option could be
allocating the change-over costs only to New Specialty Finish since we pay this extra cost
because we are trying to do New Specialty Finish. However, this could cause over-allocation
to this process, so this is not really a reliable option. After this consideration, we decided to
choose the first option and allocate the cost equally because the first option has a stronger
cause and effect relationship than the second option.

By applying this approach, profits per units are $ 0,093 and $ 3,85 for a garment of
Stonewash Finish and New Specialty Finish respectively, as shown in the tables below.

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 Change Over Costs
Salary of Workers ($25 /hour * 4 hours * 2 workers) $200
Disposable Supplies Expense $50
Total costs for one Change Over $250
Total Change Over Costs (200 change over * $250 /change over) $50.000

Stonewash Finish New Specialty Finish

Total Direct and Indirect Costs (from part 2) $318.200 $132.500
Change Over Allocated $25.000 $25.000
Total Costs $343.200 $157.500
Cost per Unit (Total Costs/ Total Garments) $1,906667 $3,150000
Profit per Unit (Selling Price – Cost per Unit) $0,093333 $3,850000

Question 4:

Before Accepting - Operating Income (from part 1) $112.500

Accepting the offer
Revenues (50000 * $7 + 180000 * $2) $710.000
Costs Cost Hierarchy
Indirect Costs
Product Sustaining Costs Product $177.500
($14000 + $37500) Sustaining
Utility Expense Output Level $103.500
($15 per machining hour* 6900
hours)
Setup Cost Batch Level $57.500
($25 per batch * 2300 batches)
Material Handling Costs Output Level $23.000
($ 0.1 / garment * 230000 garments)
Total Indirect Costs $361.500
Direct Costs
Disposable Supplies Output Level $61.200
($0.09 / garment * 180000 garments
+ 0.9 * 50000)
Shipping Costs Output Level $28.000
($ 0.1 / garment * 180000 garments
+ $ 0.2 / garment * 50000 garments )
Change-over costs ($50000) Product $50.000
Sustaining
Total Direct Costs $139.200
Total Costs $500.700
Operating Income $209.300
Incremental Profit $ 96.800

As calculated in the table above, after accepting the contract, incremental profit which
could be generated is $ 96800.

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 Question 5:

Finally, in the fifth question, it is asked to make some recommendations for Finishing

Touches. As shown in the fourth question, there was an incremental profit of $96800 when

the offer is accepted. On the other hand, there are some opportunity costs of accepting this

offer which are not shown in the financial statements of company and they are also mentioned

in the concerns of Jack Daniels, operations manager. Accepting the offer will cause idle time

for Machine 3, which is operating with full capacity, hence this idle time and related losses

should be further investigated. By the way, product sustaining costs which are sunk costs are

not taken into account and as calculated below opportunity cost of time which is caused by

change-overs is $20200. Since opportunity costs of idle time is lower than the net returns; the

company should accept the offer and use Machine 3 for New Speciality and Stonewash

finishings together.

Opportunity Cost of Idle Time

Idle Hours (200 change-overs * 3 hour) 600
Hours Allocated for Each Batch 3
Number of Batches (600/3) 200
Extra Number of Garments (200 garments/batch * 100 batches) 20000
Revenues (20000 * $2) $40.000
Costs
Utility Expense ($15 per machining hour* 600 hours) $9.000
Setup Cost ($25 per batch * 200 batches) $5.000
Material Handling Costs ($ 0.1 / garment * 20000 garments) $2.000
Disposable Supplies ($0.09 / garment * 20000 garments) $1.800
Shipping Costs ($ 0.1 / garment * 20000 garments) $2.000
Total Costs $19.800
Total Profit $20.200

On the other hand, in the long term, the company should look for other options for

Stonewash Finishing. Because not only its profits are very low with respect to the New

Speciality but also change over costs are greater than the profit which could be generated

from Stonewash finishing.