Wellington Chemicals Division

Wellington Chemicals Division Teaching Commentary

OVERVIEW

This case deals with one of the classic managerial decisions—make 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. In 1965, the exchange rate was $2.80/£. 2. 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 3. Thus, the workforce is about 15 people (£45,000 ÷ £3,000). 4. Wellington uses 40 tons of GHL per year (100,000/£500 per ton = 200 tons ÷ 5 years = 40). 5. Wellington uses 36 tons of GHL to make new containers (90%). This is 24 pounds per container. 6. 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

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

35-1 7. Since the Packages Ltd. price of £41.67 (£125,000 ÷ 3,000) is fixed for 5 years, there must be an A more sophisticated analysis would consider inflation factor included. At ~4% inflation, multi-year cash flows, taxes, tax shields, inflation and Packages is really charging about £38 the first year, the time value of money over some relevant planning with a 5-year trend of about 38, 40, 42, 44, 46. horizon. Such an analysis is presented below using a four-year horizon—the remaining life of the equipment 8. At about 5 pounds per gallon (conversion factor), and the GHL inventory. each drum holds about 1.25 tons of whatever chemical Wellington is selling.

9. 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.

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 Duffy’s estimates:

Manager 0 Foreman 5,000 (Same) Workers 9,000 (20%  45,000) GHL 2,000 (10%  20,000) Other Expenses 6,500 Per Duffy Space Costs 4,500 Same Overhead Allocation 4,500 (50%  9,000) £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 outsource.

35-2 C. Fold in Tax Considerations

1. Options 1 and 2 are enhanced by the shelter from 15,000 depreciation per year. [15,000  .4 = 6,000.] 2. 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.] 3. All the operating cash flows are only 60% as high, after taxes. 4. Losses on Sale of Machinery and GHL create tax savings in year 1:

GHL Machinery

Book Value 80 60 Salvage (64) (20) Book Loss 16 40 Tax Saved (40%) 6.4 16

D. After Tax 4 Year Cash Flows

1 2 3 4 As Above (recurring items) 509.4 597.4 582 628  .6 306 358.4 349.2 376.8 + GHL Shelter (32) (28.8) (3.2) -- + Machinery Shelter (24) (24) -- -- + Tax Saved on GHL Sale -- (.6) (5.8) (6.4) + Tax Saved on Equip. Sale -- -- (16) (16) + Salvage Value -- (6.4) (77.6) (84) 250 298.6 246.6 270.4

1 2 3 4 Make Make Containers Buy Containers Buy Options Both Buy Maint. Make Maint. Both

A. Costs Not Relevant Allocated Space Cost 4,500 Allocated Overhead 22,500 Depreciation 15,000 GHL 20,000

B. 4 Year Total Cash Flows (000) Materials (steel only) 200 200 0 0 Workers 180 144 36 12 Foreman 20 20 20 0 Manager 32 32 0 0 Other Expenses 63 37 26 0 Machinery Maintenance 14.4 14.4 0 0 Purchase Contract 0 150 500 650 Sale of GHL 0 (6.4) (57.6) (64) Sale of Equipment 0 0 (20) (20) Saved Outside Rent ______(34) Net 509.4 591 504.4 544