Downhill boards (db), a producer of snow boards, is evaluating a new process for applying the finish to its snow boards. durable finish company (dfc) has offered to apply the finish for $170,000 in fixed costs and a unit variable cost of $0.65. downhill boards currently incurs a fixed annual cost of $125,000 and has a variable cost of $0.90 per unit. annual demand for the snow boards is 160,000.

a. calculate the annual cost of the current process used at downhill boards.

b. calculate the annual cost if durable finish company applies the finish.

c. find the indifference point for these two alternatives.

d. how much of a change in demand is needed to justify outsourcing the process?

You would need to set up formulas to calculate:

Total costs = fixed cost + variable costs*quantity

A. Current process = 125,000 (fixed) + .90(VARIABLE) * 160,000 (quantity)

B. New process = 170,000 (fixed) + .65(variable) * 160,000 (quantity)

C. To find the indifference point, you would need to find the quantity where the costs of the two alternatives are equal.

125,000 + .90(x) = 170,000 + .65(x)

.25(x)=45,000

x= 180,000 units produced. This is the point where both processes equal the same costs.

D. To justify the outsourcing, you must reach the indifference point calculated above. If demand is below this point, they should stay with current process. If it is above this point, go with the new.

The answers are as follows:

a. $269, 000

b. $274, 000

c. When annual demand is 180, 000 snowboards

d. When annual demand increases by 20, 000 or more snowboards  

Explanation:

Firstly, the cost structures of both companies Downhill Boards(DB) and Durable Finish (DF) have to be established. Total annual costs comprise of total fixed costs and total variable costs. Fixed costs remain unchanged regardless of production volume whereas variable costs change with proportion to changes in manufacturing volume. Since total variable costs are a function of production volume, these costs are calculated based on estimated variable cost per unit and the level of production undertaken. The cost structures of both companies are as follows:

                                       DB                                     DF

Fixed costs                    $125,000                           $170,000

Variable costs               $144,000*                          $104,000**

(DF: 0.65; DB: 0.90)     $269,000                         $274,000

* $0.90 * 160, 000

**$0.65 * 160, 000

The point of indifference is where DB's costs of production are equal to DF's. By equating the total costs of both companies together and solving for the unknown, the indifference point can be quantified.

(($0.90 * Qd) + $125,000) = (($0.65 * 160, 000) + $170, 000

0.9 Qd + $125,000 = 0.65 Qd + $170,000

0.25 Qd = $45,000

Qd = 180, 000

At a demand of 180, 000 snow boards, DB will face the same costs of applying the finish to the snow boards. Below this amount, DB's total costs are lower since the variable costs dependent on the units demanded are lower. Above 180, 000 units, the fixed costs of DB are lower than those of DF but DB's variable costs are higher. The greater the demand in sales above the indifference point, the higher the variable costs and the cheaper it is for DB to outsource. The cost per unit after 180,000 will be higher for DB should it continue to apply the finishing. DF's lower variable costs make it cheaper for every increase in sales unit after 180, 000.

Having said this, DB's management have to decide whether to apply the finishing in house or outsource it to DF. Other than purely financial factors, DB must consider other factors such as the reputation of DF, the ability of DF to meet the set deadlines in the required time frame, delivery and quality of the finished snowboards, how to use the excess capacity that would be created after outsourcing the job and so on.

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