Bernie Steer, the production vice-president at Kahn Products, located in Amsterdam, complains that the
quality of a part used in manufacturing is poor. He states that this part costs F23 per unit (in Dutch florin)
but that 10% of the part breaks in the assembly process. This part is now purchased from a supplier that
uses a lighter gauge of steel. As a result of bending operations in assembly, it can snap at a stress point.
The supplier has been willing to split the cost of replacement parts with Kahn. The best alternative supplier
is using the higher gauge of steel was quoted a price of F28. Any price increase to cover the higher costs
would cause serious competitive problems for Kahn’s salespersons.
Breakage of this part during assembly has cause reworked and scrap costing Kahn about F150,000 in
addition to the cost of broken parts. Also, the engineering and customer service staff estimate that about
25% of the firm’s warranty claims of F660,000 last years were related to in-service failures of this part.
Sue Svatik, the controller, states that idle plant capacity exists and suggests that Kahn make its own higher
quality parts. Svatik believes that the suppliers are unwilling to reduce their profits and are cheapening
their products instead of absorbing higher metal costs.
The company needs 50,000 of this part each year. The study reveals that if Kahn produces the parts, the
following additional costs would be incurred:
Direct Material (including higher gauge of steel) F 1,050,000.00
Direct Labor (15,000 labor hours) F 225,000.00
Variable Overhead (30,000 machine hours) F 180,000.00
*Engineering believes that failure rates will become negligible.
Steer is not convinced that the components can be made at a lower cost than the purchase cost. The
plant’s substantial fixed overhead must be absorbed at a F10 per machine rate hour. In Steer’s opinion,
use of any idle capacity should cover at least this fixed overhead.
Requirement:
1. Based on the quantitative data given, how should the part be sourced? Show computations.
Kahn Products’ part should be sourced from the supplier using a higher gauge of steel at a cost
of F28 per unit (option2). Purchasing of a lighter gauge of steel which the company is currently
using incurs additional cost such as replacement cost for broken parts, rework and scrapping cost,
and warranty cost which resulted to F30.45 (option1), a bit higher than purchasing a more quality
gauge of steel. Moreover, making own high quality parts will result to a higher cost of F29.10
(option3) which includes direct materials of high quality gauge of steel, direct labor and variable
overhead. Therefore, Kahn Products’ should consider the best alternative that will incur a lower
variable cost which is purchasing a higher gauge of steel.
2. Evaluate Steer’s argument. Does he make a valid point?
Steer’s argument is overall invalid because purchasing or producing the part will still incur fixed
overhead, making fixed overhead costs irrelevant to the decision making process aiming for
profitability. Furthermore, in-house production of the parts would incur higher costs than
purchasing the parts from the new supplier with a higher gauge of steel (Option2).
3. Discuss the possible long-term ramifications of this decision on the factory, on sales, on
customers, and on profits.
If Kahn Products chooses to purchase the parts to a new supplier with higher gauge of steel, the
company will incur lower production costs therefore maintaining its competitive pricing that the
salespersons can use against competitors. The second option offers a reduction on costs without
sacrificing the quality of the product, therefore customers are assured that Kahn Products will
deliver high quality goods in the long run which will result in increasing of sales. The negligibility
of warranty costs due to parts breakage will also ensure that the products are of better quality,
gaining customer loyalty in the long run. The reduction of costs from replacement costs, rework
and scrapping costs, and warranty costs shall increase the profitability of the company. In the long
run, assured quality, lower costs, and customer loyalty will continue to increase the profit of Kahn
Products.
