Decision Making Case
Kensigton family
The Kensington family lives in Dallas, Texas. Mr. and Mrs. Kensington have been married for 50 years and have six children - three sons - Rob, Patrick and Ewan and three daughters - Kate, Ali and Angela. All six attended the Southern Methodist University. They are well educated and well settled individuals. However, last few months have been hard on all of them and each is facing a critical decision at his or her work. They flew in for a weekend last week where they discussed the issues at the family dinner.
Robert, the first born runs a sports business and has 12 employees. The name of his company is Mystic, Inc. They produce a variety of products that carry the logos of teams in the Southern Football League (SFL). The company recently paid the league $85,000 for the rights to market a popular player jersey and immediately began production. They manufactured 25,000 jerseys at the cost of $625,000. The amount of manufacturing costs paid to-date is $410,000. They have not sold a single jersey to date. They expect to spend $330,000 on future marketing costs and sell the jersey for $42 each. The SFL is about to file a lawsuit to stop jersey sales and is demanding another $50,000 from Mystic for the manufacturing rights. Conversations with Mystic's attorneys indicate that the league has a strong case and is likely to win the suit. If this situation arises, Mystic will be unable to recover any amounts paid to the SFL. Rob is really worried.
Kate, the second born, married into a successful business family Stower. The Stowers family has a business named Stowers Corporation which manufactures products J, K, and L in a joint process. John Stowers, Kate's husband, runs the business. He recently took over the reins of the family from his father Jim Stowers. Kate has an MBA from the Olin Business School. John often seeks help from Kate on business matters. Recently he asked her for advice relating to the three products - at what stage should they be sold off? Kate consulted with the management accountant and found that the company incurred $480,000 of joint processing costs during the period just ended and had the following data that related to production:
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Sales Values and Additional Cost if Processed Beyond Split-off
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Product
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Sales Value at Split-off
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Sales Value
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Additional Cost
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J
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$400,000
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$550,000
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$130,000
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K
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350,000
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540,000
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240,000
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L
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850,000
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975,000
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118,000
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An analysis revealed that all costs incurred after the split-off point are variable and directly traceable to the individual product line. She has asked John to be more specific with the questions he needs advice on.
Patrick is an engineer with a MBA degree. He works at a very senior position at Fowler Industries. They produce two bearings: C15 and C19. Data regarding these two bearings follow.
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C15
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C19
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Machine hours required per unit
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2.00
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2.50
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Standard cost per unit:
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Direct material
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$ 2.50
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$ 4.00
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Direct labor
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5.00
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4.00
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Manufacturing overhead:
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Variable*
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3.00
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2.50
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Fixed**
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4.00
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5.00
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Total
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$14.50
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$15.50
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*Applied on the basis of direct labor Hours
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**Applied on the basis of machine hours
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The company requires 8,000 units of C15 and 11,000 units of C19. Recently, management decided to devote additional machine time to other product lines, resulting in only 31,000 machine hours per year that can be dedicated to production of the bearings. An outside company has offered to sell Fowler the bearings at prices of $13.50 for C15 and $13.50 for C19. Patrick is not sure what the right decision is.
Ali went to the Baylor College of Medicine. She now is the Chief at St. Joseph Hospital. The hospital has been hit with a number of complaints about its food service from patients, employees, and cafeteria customers. These complaints, coupled with a very tight local labor market, have prompted the organization to contact Nationwide Institutional Food Service (NIFS) about the possibility of an outsourcing arrangement. The hospital's business office has provided the following information for food service for the year just ended: food costs, $890,000; labor, $85,000; variable overhead, $35,000; allocated fixed overhead, $60,000; and cafeteria sales revenue, $80,000. Conversations with NIFS personnel revealed the following information:
• NIFS will charge St. Joseph Hospital $14 per day for each patient served. Note: This figure has been "marked up" by NIFS to reflect the firm's cost of operating the hospital cafeteria.
• St. Joseph's 250-bed facility operates throughout the year and typically has an average occupancy rate of 70%.
• Labor is the primary driver for variable overhead. If an outsourcing agreement is reached, hospital labor costs will drop by 90%. NIFS plans to use St. Joseph facilities for meal preparation.
• Cafeteria sales revenue is expected to increase by 15% because NIFS will offer an improved menu selection.
Ali would much prefer concentrate on the medical decision than the administrative details but as a Chief she needs to handle the administrative issues.
Ewan, the youngest son owns a pizza chain - Papa Fred's Pizza. Store no. 16 has fallen on hard times and is about to be closed. The following figures are available for the period just ended:
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Sales
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$205,000
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Cost of sales
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67,900
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Building occupancy costs:
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Rent
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36,500
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Utilities
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15,000
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Supplies used
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5,600
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Wages
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77,700
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Miscellaneous
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2,400
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Allocated corporate overhead
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16,800
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All employees except the store manager would be discharged. The manager, who earns $27,000 annually, would be transferred to store no. 19 in a neighboring suburb. Also, no. 16's furnishings and equipment are fully depreciated and would be removed and transported to Papa Fred's warehouse at a cost of $2,800.
Angela is an architect. She is married to Greg Smithson. They build custom homes in Cincinnati. The Smithsons were approached not too long ago by a client about a potential project, and they submitted a bid of $590,000, derived as follows:
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Land
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$ 90,000
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Construction materials
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120,000
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Subcontractor labor costs
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150,000
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$360,000
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Construction overhead: 20% of direct costs
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72,000
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Allocated corporate overhead
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40,000
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Total cost
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$472,000
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The Smithsons add a 25% profit margin to all jobs, computed on the basis of total cost. In this client's case the profit margin amounted to $118,000 ($472,000 * 25%), producing a bid price of $590,000. Assume that 60% of construction overhead is fixed. They received a counter offer from the client and are faced with the decision to sell or not to sell.
All of them are very worried with the recent decisions that they face at work. You have been kind enough to offer them help. Can you help them decide the following issues?
Required (Show computations to support your answers):
1. Mystic's sales department anticipates very strong demand and a sellout of all jerseys manufactured.
a. Determine the overall profitability of the jersey product line if Mystic settles the disagreement with the SFL and the anticipated sellout occurs.
b. Should Mystic pay the additional $50,000 demanded by the league or should the jersey program be dropped?
2. Can you help Kate with the following?
a. If Stowers allocates joint costs on the basis of the products' sales values at the split-off point, what amount of joint cost would be allocated to product J?
b. If production of J totaled 50,000 gallons for the period, determine the relevant cost per gallon that should be used in decisions that explore whether to sell at the split-off point or process further? Briefly explain your answer.
c. At the beginning of the current year, Stowers decided to process all three products beyond the split-off point. If the company desired to maximize income, did it err in regards to its decision with product J? Product K? Product L? By how much?
3. Assume that Fowler decided to produce all C15s and purchase C19s only as needed.
a. Determine the number of C19s to be purchased.
b. Compute the net benefit to the company of manufacturing (rather than purchasing) a unit of C15. Repeat the calculation for a unit of C19.
c. Fowler lacks sufficient machine time to produce all of the C15s and C19s needed. Which component (C15 or C19) should Fowler manufacture first with the limited machine hours available? Why?
4. Can you help the Chief of the Hospital, Ali, make the following decisions?
a. Should St. Joseph outsource its food-service operation to NIFS?
b. What factors, other than dollars, should St. Joseph consider before making the final decision?
5. Can you help Ewan with the following?
a. What is store no. 16's reported loss for the period just ended?
b. Should the store be closed? Why?
c. Would Papa Fred's likely lose all $205,000 of sales revenue if store no. 16 were closed? Explain.
6. Suppose that the Smithsons business is presently very slow, and the client countered with an offer on this home of $455,000.
a. Should Smithson accept the client's offer? Why?
b. If Smithson has more business than he can handle, how much should he be willing to accept for the home? Why?