This is “How Are Relevant Revenues and Costs Used to Make Decisions?”, chapter 7 from the book Accounting for Managers (v. 1.0).
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Bob Lee is president of Best Boards, Inc., a manufacturer of wakeboards. In the face of stiff competition, Best Boards’ profits have declined steadily over the past few years. Bob is concerned about the decline in profits and has instructed Jim Muller, the vice president of operations, to do whatever it takes to reduce costs. In fact, Bob offered to pay Jim a bonus equal to 25 percent of any production cost savings the company achieves during the coming year.
Jim Muller thinks he has a way to cut costs and earn his bonus, and he approaches Bob Lee and Amy Eckstrom, the company’s accountant, to discuss his plan:
|Jim:||Bob and Amy, I hope you’ve had a chance to review my proposal to outsource production. I think it could save the company thousands of dollars this coming year.|
|Bob:||I did review your proposal. Give me a quick summary of what you have in mind.|
|Jim:||Our staff accountants tell me that the average unit product cost for our wakeboards is about $110, and we make 10,000 wakeboards each year.|
|Amy:||Sounds about right.|
|Jim:||My thought is that we could save substantial amounts of money by having an outside supplier make our wakeboards rather than doing it ourselves. I contacted one reputable wakeboard manufacturer interested in producing the boards for us.|
|Bob:||What did you find?|
|Jim:||They told me the wakeboards could be purchased from them for $70 a board. This amounts to $40 in savings per unit, and $400,000 in total savings! Even after my 25 percent bonus of $100,000, Best Boards would save $300,000.|
|Amy:||Jim has an interesting idea, but there are some issues that should be considered. Jim, you are correct in stating the average unit product cost for our wakeboards is $110 given production of 10,000 units per year. However, it is not accurate to assume we will eliminate $1,100,000, which is $110 per unit cost times 10,000 units, in total production costs by outsourcing production. The average unit cost includes factory equipment lease payments, along with supervisors’ salaries, and factory rent. These costs don’t go away quickly if we stop production. The equipment lease is for several years, we are locked into a long-term lease for the factory building, and we would have to look at our supervisors’ contracts before letting them go.|
|Bob:||Can we get a better idea of which costs would be eliminated by outsourcing production, and which costs would remain?|
|Amy:||Sure. I’ll get a team working on this right away.|
Best Boards is facing a decision common to many organizations: whether to build its own product or to have another company build the product. We will come back to this scenario after describing how companies facing such decisions can use differential analysis to make wise business decisions.