Reichard Machinen
...se modest startup costs are “sunk,” the differential or incremental costs to produce 100 plastic rings is $32.28. Study question 2. Question 2 asks for the incremental cost to produce the next 34,500 steel rings—i.e., the rings that can be made from the inventory of raw steel that GMD has on hand. This special steel has already been purchased and has no alternative market. Since the scrap value of the steel used to make the rings is zero, the opportunity cost of the raw material is also zero. Thus, there is zero further raw material cost, explicit or implicit, involved in the use of the raw steel to produce rings. The labor cost for manufacturing steel rings in July and August also involves some analysis. It can be argued that the incremental cost of direct labor is only 30 percent of the normal labor rate, given GMD’s labor policy of keeping employees working through slack production periods by paying them 70 percent of their normal wages to do make-work projects. The numbers in Exhibit 2 assume that these projects have no real value to the company. The incremental cost of shifting workers to production of steel rings would thus be only the 30 percent increment GMD would pay to bring the workers up to their full wage rates. The variable overhead (due largely to fringe benefits related to direct labor) amounts to about 80 percent of labor cost, and the incremental variable overhead cost will be 30 percent of normal costs. Consequently, as Exhibit 2 shows, the incremental cost per 100 rings to produce the next 34,500 steel rings over the summer is $25.27. Study question 3. Question 3 asks for the differential cost of the 25, 450 steel rings already in inventory at the end of May. The idea here is that the 25,450 finished steel rings in inventory have zero differential cost. No additional work needs to be done on these rings. Even though they carry a value of $263.85 per 100 rings in inventory, no additional expenditure is required to sell the rings. Study question 4. Questions 1, 2, and 3 set up the analysis for question 4, which asks which ring is more profitable—steel or plastic. Another layer of complexity is added here because of the unequal lives of the steel and plastic rings. If a plastic ring has about four times the life of a steel ring, the market demand (in units) for the plastic rings is likely to be significantly less than the current demand for steel rings. If GMD switches to plastic rings but does not increase its market share, it can expect to sell only about 25 percent as many rings as it does now. Relevant costs and profits The relevant cost and profit calculations for the steel and plastic rings are shown in Exhibit 3. For purposes of this analysis, we first assume the same current selling prices for steel rings and plastic rings. (The implications of relaxing this assumption are discussed later.) The profitability of plastic and steel rings can be compared assuming the following four scenarios: 1. Plastic rings vs. the 25,450 steel rings already in stock; 2. Plastic rings vs. the next 34,500 steel rings that can be produced over the summer; 3. Plastic rings vs. future steel rings using contribution analysis; and 4. Plastic rings vs. future steel rings using full cost analysis. Scenario 1: Plastic rings vs. the 25,450 steel rings in stock. When plastic rings are compared with the 25,450 steel rings now in inventory, the steel rings are far more profitable because their marginal cost is zero. Any revenue gained from their sale is incremental profit contribution at this point. Assuming the current sale prices of $325 per hundred for steel rings and $340 per hundred for...