Flower Pharmaceuticals has been offered a one-year contract to produce acetaminophen (a popular painkiller) for a chain of drug stores. The chain intends to affix its own label and market the product as a generic substitute for the national brands. Flower currently competes in the acetaminophen market selling its own nationally advertised brand. Until recently, demand for Flower’s own product exceeded production capabilities. However, increased competition in the acetaminophen market combined with the introduction of new over-the-counter painkillers (primarily ibuprofen) has greatly reduced Flower’s demand. As a result, Flower is currently operating each of its four production lines at only 65 percent capacity. Steve Spencer, Vice-President of Sales, must decide whether to accept the contract. Mr. Spencer has been analyzing the following information. The chain-store contract would require Flower to devote one of the four existing lines to the chain-store’s production. Capital costs and overhead for the plant are equal to $400,000 per year. Flower Pharmaceuticals uses a labor cost of $15 per hour. This figure is obtained by taking the production workers’ $10 wage and adding a 50 percent fringe benefit package. The firm then calculates managerial overhead at two-thirds of hourly wages and benefits. The firm adds a profit margin of 100 percent of the sum of direct labor costs and managerial overhead. If Flower accepts the contract, it will be necessary to recall 75 hourly paid workers who were laid off because of slack demand. Total labor requirements for the chain-store project will be 124,000 hours. The 75 workers to be recalled are currently covered under a clause in Flower’s labor contract required that laid off workers be paid their base salary plus fringe benefits based upon a 40-hour week for a period of eight weeks. The 75 workers that Flower would be recalling have already received four weeks of these severance benefits. The chain-store project would require purchasing $500,000 in new materials. The firm would also use 25,000 pounds of powder base that is currently being held in inventory. The base was purchased for $250,000 and the firm’s accountants have assessed and additional $45,000 handling charge for the time that it has been in inventory. The powder base currently sells for $9 per pound delivered. Flower’s managers are considering the project on a one-year temporary basis. The firm’s managers anticipate cultivating new markets to bring the firm back to full capacity without relyingupon the chain-store contract. Flower’s accountants have estimated the following costs for the project: (1). Fully Allocated Capital Cost 1 of 4 lines of ¼ of $400,000 $100,000 (2). Direct Labor Cost ($15 x 124,000). 1,860,000 (3). Materials Purchased. 500,000 Inventoried. 295,000 795,000 (4). Managerial Overhead ($10 x 24,000). 1,240,000 (5) Profit Margin ($25 x 124,000) 3,100,000 $7,095,000
a. For each category, determine whether the cost is relevant and whether it is an explicit or implicit (opportunity) cost for undertaking this project. Also, determine whether the cost has been properly calculated (if the calculation is incorrect, give the correct figure). If you determine that a cost is irrelevant, you need not identify whether the cost is implicit or explicit. If you determine that a cost is relevant and implicit, you must identify the lost opportunity. Explain your answers. You will not get credit for simply having correct numbers. Be specific and explain your reasoning for each cost item.
b. Calculate the relevant cost of the project for Flower. What is the lowest amount the firm should accept for the contract? Explain
c. Explain how your answers in parts a and b would change if the firm was currently operating at full capacity. Be specific, and re-calculate the relevant cost of the project.