Karsten Mills is one of the premier carpet manufacturers in the world. It manufactures carpeting for both residential and commercial applications. Home sales and commercial sales each account for about 50 percent of total revenue. The firm is organized into three departments: manufacturing, residential sales, and commercial sales. Manufacturing is a cost center and the two sales departments are profit centers. The full cost of each roll of carpeting produced (including fully absorbed overhead) is transferred to the sales department ordering the carpet. The sales departments are evaluated as profit centers; the full cost of each roll is the transfer price.
The current manufacturing plant is at capacity. A new plant is being built that will more than double the capacity. Within two years, management believes that it can grow Karsten's businesses such that most of the excess capacity will be eliminated. When the new plant comes on line, one plant will produce exclusively commercial carpeting and the other will produce exclusively residential carpeting. This change will simplify scheduling, ordering, and inventory control in both plants and will create some economies of scale through longer millruns. Nevertheless, it will take a couple of years before these economies of scale can be realized.
Each mill produces carpeting in 12-foot-wide rolls of up to 100 yards in length. The output of each mill is measured in yards produced. Overhead is assigned to carpet rolls using carpet yards produced in the mill. The cost structure of each plant is as follows:
Old Plant New Plant
Normal machine hours per year 6,000 5,000
Normal carpet yards per hour 1,000 1,400
Normal capacity 6 million yards 7 million yards
Annual manufacturing overhead costs
excluding accounting depreciation $15,000,000 $21,000,000
Accounting depreciation per year $ 6,000,000 $21,000,000
Besides being able to run at higher speed, producing more carpet yardage per hour, the new mill will use 15 percent less direct material and direct labor because the new, more automated machines produce less scrap and require less direct labor per yard. The cost ofa job run at the old mill is
Carpet A6106: (100-Yard Roll)
Direct materials $800
Direct labor 600
Direct costs $1,400
Although the new mill has lower direct costs of producing carpeting than the old mill, the higher overhead costs per yard at the new mill have the sales department managers worried. They areal ready lobbying senior management to have the old mill assigned to produce their products. The commercial sales department manager argues, "More of my customers are located closer to the old plant than are residential sales' customers. Therefore, to economize on transportation costs, my products should be produced in the old plant." The residential sales department manager counters with the following argument: "Transportation costs are less than1 percent of total revenues. The new plant should produce commercial products because we expect new commercial products to use more synthetic materials and the latest technology at the new mill is better able to adapt to the new synthetics." Senior management is worried about how to deal with the two sales the new plant. One suggestion put for this for each plant to produce about half of commercial sales products and about half of residential sales products. But this proposal would eliminate most of the economies of scale that would result from specializing production in each plant to one market segment.
Required:
a. Calculate the overhead rates for the new plant and the old plant, where overhead is
assigned to carpet based on normal yards per year.
b. Calculate the expected total cost of carpet A6106 if run at the old mill and if run at the new mill.
c. Put forth two new solutions that would overcome the resistance of the residential and
commercial sales department managers to the new plant. Discuss the pros and cons of your
two solutions.