To: Mike Lewis
From: Overseas Consulting Group
Date: December 9th 1990
Subject: Manifolds Retention vs. Outsourcing Analysis
Our team of financial analysts has taken an in depth look at the consultant’s recommendation to potentially outsource the manifold production line. Through our analysis you will see that the consultants have not considered the full financial impact that this outsourcing would have on the company. This is likely because the recommendation has not taken into consideration the range of costs affecting Bridgeton industries. Through our analysis it becomes clear that the decision to retain the manifold production line will be more financially beneficial to the company. We will begin with some of the assumptions of our analysis, and the conclusions from our various analyses of Bridgeton Industries Costs. Please refer to the attached excel file for detailed analysis of the numbers.
We know that Bridgeton uses an absorption costing system which does not easily distinguish between fixed and variable costs. The problem with that system makes it very challenging to forecast appropriately the cost of excess capacity and furthermore the impact of outsourcing the manifold production line. Therefore the reported costs are not appropriate for this type of analysis. Our team began our own analysis of the costs to evaluate the recommendation. We began by calculating gross margin for each product, by first identifying how much overhead should be allocated to each category. We broke out the overhead by using Direct Labor (DL) as a % since most of the overhead accounts are labor related. As a result, overhead allocation for each product in 1987 is the following: Fuel Tanks 17%, Manifolds 24%, Doors 11%, Muffler/Exhausts 23%, and Oil Pans 26% for 1987. Muffler/Exhausts, manifolds and Oil Pans are both labor intensive, so under this method, they bear a higher percentage of the overhead costs. Now that Bridgeton stopped producing Muffler/Exhausts and Oil Pans, the manifold line carries an even greater proportion of the overhead costs of 46%. Therefore, the cost per manifold goes up because of the larger share of overhead it has to absorb.
Please refer to the analysis file, tab 2 for 1991 forecasts. We assumed the sales and costs for each category would increase close to the same percentage as previous year. The overhead forecast required greater detailed analysis. The question is how to anticipate how much overhead would go down due to discontinuation of manifolds. In 1989, DL and direct material (DM) went down 46% and 47% respectively from the outsourcing of the other production lines. If manifolds were to be outsourced and all DL and DM were eliminated, then we are looking at approximately 44% decrease in DL and 49% decrease in DM. We assumed for the purpose of our analysis, that the reductions in DL and DM for these two year are comparable. Thus, we applied the same percentage of overhead reduction in each account to the 1989 to the 1991 overhead accounts.
Once we established these overhead accounts, we then analyzed how the costs are allocated across the remaining lines. As you can see in detailed spreadsheet, the most profitable product, the fuel tanks, now has to absorb 61% of the overhead cost and its gross margin is down to 33% from 43%. The doors’ gross margin also went south from 27% to 17%. Clearly the fixed costs, which weren’t removed with the outsourcing, have eroded the profitability of all of the remaining products.
The consultant’s suggestion to outsource production is actually not a good option after all. Fix costs embedded in the cost per unit won’t go away because less profitable parts are outsourced. If Bridgeton industries wants to seriously considering outsourcing the manifold line or any other some significant overhead restructuring is necessary to try and reduce the fixed cost profitability dilution.
Changes to cost structure
As we mentioned...