Wellington Chemicals Division Teaching Commentary

OVERVIEW

This case deals with one of the classic managerial decisionsmake versus buy.

Most courses in managerial accounting include at least one make/buy problem to illustrate the applicability of relevant cost analysis in thinking about such decisions. This case is rich enough to support a fully-articulated relevant cost analysis. It also will support a strategic analysis with a little more digging by the students. It is a great case to illustrate different cost analysis frameworks for a classic management decision. CASE ANALYSIS The following list includes intermediate calculations/estimates which can be derived either from the case or from some basic library research. At Tuck, I expect the students to be able to derive items such as these on their own. Some instructors prefer to make this list available to students along with the case to simplify the assignment. 1. 2. In 1965, the exchange rate was $2.80/. A worker is probably making about 3,000/year. - A 1,500 pension at about 50% of regular pay - The foreman makes 5,000, and a worker would be about 50% to 75% of that - A US chemicals worker made about $7,000 (before fringes) in 1965 = ~2,500 Thus, the workforce is about 15 people (45,000 3,000). Wellington uses 40 tons of GHL per year (100,000/500 per ton = 200 tons 5 years = 40). Wellington uses 36 tons of GHL to make new containers (90%). This is 24 pounds per container. How large are the containers? Steel Cost = 50,000 (70,000 - 20,000) In 1965, basic steel cost $360/ton in the U.S. This is about 390 tons of steel (50,000 2.8 = $140,000 $360/ton) For 3,000 new containers, this is ~260 pounds per container, which is pretty big A standard 55 gallon drum weighs about 30 pounds Thus each drum holds probably about 500 gallons

3. 4. 5. 6.

This teaching commentary was prepared by Professor John K. Shank of the Amos Tuck School of Business.

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7.

Since the Packages Ltd. price of 41.67 (125,000 3,000) is fixed for 5 years, there must be an inflation factor included. At ~4% inflation, Packages is really charging about 38 the first year, with a 5-year trend of about 38, 40, 42, 44, 46. At about 5 pounds per gallon (conversion factor), each drum holds about 1.25 tons of whatever chemical Wellington is selling. If the current GHL price of 600/T is typical for specialty chemicals, the sales value of one drum full of chemicals is about 750.

outsource. A more sophisticated analysis would consider multi-year cash flows, taxes, tax shields, inflation and the time value of money over some relevant planning horizon. Such an analysis is presented below using a four-year horizonthe remaining life of the equipment and the GHL inventory.

8.

9.

10. It is not clear how Administrative Overheads are allocated, but 22,500 is 50% of hourly labor. Allocation based on direct labor would have been very typical in 1965. 11. The cost at Wellington for maintenance only is as follows, per Duffys estimates: Manager Foreman Workers 45,000) GHL 20,000) Other Expenses Space Costs Overhead Allocation 9,000) 0 5,000 (Same) 9,000 (20% 2,000 (10% 6,500 Per Duffy 4,500 Same 4,500 (50% 31,500 12. Each new drum thus costs 52.6 (189,350 - 31,500 3,000), fully absorbed. This compares to the buy cost of ~38 (point #7) in 1965. 13. The drums are re-used many times, according to the case, with regular maintenance. Since each drum is used 12 times, on average, the cost per use is only about 4.4, which is less than 1% of the value of the contents (estimated at 750). Taking a very simple view of the problem, the following series of arguments can be made: Level 1 We make everything that is important because that is the only way to maintain full control. Level 2 Buying is cheaper (189,350 versus 162,500), so outsource if possible. Level 3 On an incremental cost basis, making is cheaper (162,500 versus 147,350 [189,350 less depreciation of 15,000 and less allocated costs of 4,500 and 22,500]), so do not 35-2

C. Fold in Tax Considerations 1. 2. 3. 4. Options 1 and 2 are enhanced by the shelter from 15,000 depreciation per year. [15,000 .4 = 6,000.] There is also tax shelter from the GHL which is a noncash charge. [8,000 for option 1 (20,000 .4), 7,200 for option 2 and 800 for option 3.] All the operating cash flows are only 60% as high, after taxes. Losses on Sale of Machinery and GHL create tax savings in year 1: GHL Book Value Salvage Book Loss Tax Saved (40%) 80 (64) 16 6.4 Machinery 60 (20) 40 16

D. After Tax 4 Year Cash Flows 1 509.4 306 (32) (24) ---250 2 597.4 358.4 (28.8) (24) (.6) -(6.4) 298.6 3 582 349.2 (3.2) -(5.8) (16) (77.6) 246.6 4 628 376.8 --(6.4) (16) (84) 270.4

As Above (recurring items) .6 + GHL Shelter + Machinery Shelter + Tax Saved on GHL Sale + Tax Saved on Equip. Sale + Salvage Value

Options A. Costs Not Relevant

1 Make Both

2 Make Containers Buy Maint.

3 Buy Containers Make Maint.

4 Buy Both

Allocated Space Cost Allocated Overhead Depreciation GHL B. 4 Year Total Cash Flows (000) Materials (steel only) Workers Foreman Manager Other Expenses Machinery Maintenance Purchase Contract Sale of GHL Sale of Equipment Saved Outside Rent Net

4,500 22,500 15,000 20,000

200 180 20 32 63 14.4 0 0 0 ____ 509.4 35-3

200 144 20 32 37 14.4 150 (6.4) 0 ____ 591

0 36 20 0 26 0 500 (57.6) (20) ____ 504.4

0 12 0 0 0 0 650 (64) (20) (34) 544