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Relevant costs

My company manufactures private-label small electronic products, such as alarm clocks, kitchen timers, stopwatches, and automatic pencil sharpeners, some of the products are sold as assets, and others are sold individually. Products are studies as to their sales potential, and then cost estimates are made, the Engineering Department develops production plans, and then production begins, the company has generally had very successful product introduction, only two products introduced by the company have been discontinued.

One of the products currently sold is a multi-alarm alarm clock. The clock has four alarms that can be programmed to sound at various times and for varying lengths of time. The company has experienced a great deal of difficulty in making the circuit boards for the clocks. The production process has never operated smoothly. The product is unprofitable at the present time, primarily because of warranty repairs and product recalls. Two models of the clocks were recalled, for example, because they sometimes caused an electric shock when the alarms were being shut off. The Engineering Department is attempting to revise the manufacturing process, but the revision will take another 6 months at least.

The clocks were very popular when they were introduced, and since they are private label, the company has not suffered much from the recalls. Presently, the company has a very large order for several items from Kmart Stores. The order includes 5,000 of the multi-alarm clocks. When the company suggested that Kmart purchase the clocks from another manufacturer, Kmart threatened to rescind the entire order unless the clocks were included.

The company has therefore investigated the possibility of having another company make the clocks for them. The clocks were bid for the Kmart order based on an estimated $6.65 cost to manufacture:

Circuit board, 1 each @ $2.00 $2.00
Plastic case, 1 each @ $0.75 0.75
Alarms, 4 @ $0.10 each 0.40
Labor, 15 minutes @ $12/hour 3.00
Overhead, $2.00 per labor hour 0.50

My company could purchase clocks to fill the Kmart order for $11 from Silver Star, a Korean manufacturer with a very good quality record. Silver Star has offered to reduce the price to $7.50 after my company has been a customer for 6 months, placing an order of at least 1,000 units per month. If my company becomes a "preferred customer" by purchasing 15,000 units per year, the price would be reduced still further to $4.50.

Alpha Products, a local manufacturer, has also offered to make clocks for my company. They have offered to sell 5,000 clocks for $4 each. However, Alpha Products has been in business for only 6 months. They have experienced significant turnover in their labor force, and the local press has reported that the owners may face tax evasion charges soon. The owner of Alpha Products is an electronic engineer, however, and the quality of the clocks is likely to be good.
If my company decides to purchase the clocks from either Silver Star or Alpha, all the costs to manufacture could be avoided, except a total of $5,000 in overhead costs for machine depreciation. The machinery is fairly new, and has no alternate use.

(a) What is the difference in profit under each of the alternatives if the clocks are to be sold for $14.50 each to Kmart?
(b) What are the most important nonfinancial factors that my company should consider when making this decision?
(c) What should my company do in regard to the Kmart order? What should it do in regard to continuing to manufacture the multi-alarm alarm clocks?

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Solution Summary

The solution explains how to calculate the cost of different alternatives using relevant costs.