Problem
The Kamloops Outdoors Corporation, which produces a highly successful line of summer lotions and insect repellents and sells them to wholesalers, has decided to diversify in order to stabilize its sales throughout the year. A natural area for the company to consider is the production of winter lotions and creams to prevent dry and chapped skin.
After considerable research, the company has developed a winter products line. However, because of the conservative nature of company management, the president has decided to introduce only one of the new products for this coming winter. If the product is a success, there will be further expansion in future years.
The product selected is a lip balm to be sold in a lipstick-type tube. The company will sell the product to wholesalers in boxes of 24 tubes for $16.00 per box. Because of available capacity, the company will incur no additional fixed charges to produce the product. However, to allocate a fair share of the company's present fixed costs to the new product, the product will absorb a $130,000 fixed charge.
Using the estimated sales and production of 100,000 boxes of lip balm as the standard volume, the accounting department has developed the following costs per box of 24 tubes:
Direct labour $3.80
Direct materials 5.80
Total overhead 2.80
Total $12.40
Kamloops Outdoors has approached a cosmetics manufacturer to discuss the possibility of purchasing the tubes for the new product. The purchase price of the empty tubes from the cosmetics manufacturer would be $1.90 per 24 tubes. If Kamloops Outdoors accepts the purchase proposal, it is estimated that direct labour and variable overhead costs would be reduced by 10% and direct materials costs would be reduced by 20%.
Instead of sales of 100,000 boxes, revised estimates show a sales volume of 125,000 boxes. At this new volume, the company must acquire additional equipment, at an annual rental charge of $10,000, to manufacture the tubes. However, this incremental cost would be the only additional fixed cost, even if sales increased to 300,000 boxes. (The 300,000 level is the goal for the third year of production.) Under these circumstances, should Kamloops Outdoors make or buy the tubes?