Question

DONLEY BROTHERS

The Donley Brothers Company had encountered the problem of latent defects in some of its purchased castings. Being latent, the defects did not show up until after machining had taken place at Donley

Brothers. This group of failures greatly irritated the manufacturing boss, who declared that “repairing

those darn castings is eating up all our profits.”

When the defects were discovered, the rough casting had to be taken off the machine, the defect

chipped out and repair-welded, and the casting remachined when possible. Even with this process, almost

12 percent of the incoming castings ended up as scrap. Actually, 1,140 raw castings had to be purchased

and machined in order to produce 1,000 good machined ones. The raw castings cost $600 each from

either of two suppliers. Worse than the costs associated with rework and high scrap rates were the

continual changes in production scheduling necessitated by a machined casting not being available as

scheduled. These changes were costly because they required shop personnel to tear down the job they

were working on and set up a new job. Marketing was constantly complaining about the firm’s inability

to meet delivery commitments for the finished machinery that incorporated the castings. Marketing

claimed that many sales were lost as a result of this failure.

George Donley, the production manager, and Terry Donley, the vice president for marketing,

asked Bob Donley, the supply manager, to investigate the costs involved in supplying finished machined

castings. If finished castings were purchased, the responsibility for finding hidden defects would be that

of the supplier. Such action would encourage the supplier to improve the casting quality. Donley Brothers would accept and pay only for finished, usable castings.

The internal cost of machining each incoming rough casting and repair-welding and remachining

it, as necessary, was approximately $312 per casting. This figure included $156 of direct labor and $156

of overhead. The accounting department estimated that overhead, which was 100 percent of direct labor,

consisted of 50 percent variable and 50 percent fixed costs. No estimate was available on the cost of

disrupted production schedules and operations.

Bob approached all his major suppliers of castings in an attempt to generate interest for the

supply of finished machined castings. Only one supplier, Akron Foundry, showed genuine interest. Of

major concern to all the foundries was the $120,000 to $160,000 investment necessary to set themselves

up to machine the raw castings. Akron was willing both to invest in the necessary machines and to

guarantee delivery of up to 150 units per month—provided Donley Brothers would contract with it as a

sole source for the castings for the next three years. The price per casting would be $1,000 the first year,

with an annual increase or decrease in price tied to an appropriate economic index.

Bob was faced with the problem of deciding whether to recommend contracting with Akron

Foundry for finished castings, continuing as in the past buying rough castings, or developing a more

attractive alternative. The Donley machine shop was currently operating at 90 percent of capacity, but it

was not possible to make a reliable estimate of what would happen in the next few months, let alone the

next three years. The decision of whether to buy finished castings was of major dollar importance to Donley Brothers because the firm used at least 1,000 finished castings per year and anticipated that this

usage would continue for each of the next five years.

1. In the Donley Brothers case (reprinted later in this exam) that we studied, let’s say that we could purchase an inspection process that is able to screen the incoming rough castings to find the latent defective castings and send only the good castings to machining. This inspection is 100% reliable; i.e., it always finds the defective castings, and never is in error. Unfortunately, the contract with our suppliers does not allow us to send back the defective castings for credit; we still have to buy 1140 castings to get the 1000 good ones. We will, however, only have to machine good castings. Since we would now only have to machine good castings, the cost accountants recalculated the cost under this new situation; the new costs would be direct labor of $100 per unit, plus overhead of 167% of direct labor (of which $78 per unit is variable overhead and the rest is fixed). These costs only apply to this situation where we are machining only good castings.

Assume that we still have the reject rate for rough castings as discussed in the case and we will not purchase the machined castings from Akron. Assume that other costs that cannot be determined, such as disruption and lost sales costs, will not be factored into this analysis. Assume that the annual demand will be 1000 good machined castings per year (as was discussed in the case).

      What is the maximum annual amount that you would be willing to pay for the inspection process? Justify this amount and provide your numerical analysis.

Answer 1

Donley case:

Cost to make 1000 good machined castings per year is -

Raw material casting = $600 * 1140 = 684,000

Labor = $156 * 1140 = $177,840

Overhead = $156 * 1140 = $177,840

Total = raw material casting + labor + overheads

= 684,000 + 177,840 + 177,840 = $1,039,680

Cost to purchase 1000 finished castings = 1000 * $1000 = $1,000,000

Annual variable cost = $600 * 1140 = $684,000

Labor = $156 * 1140 = $177,840

Variable overhead = $78 * 1140 = $88,920

Total = $684,000 + 177,840 + 88,920 = $950,760

Contribution to overheads = $1,000,000 - $950,760 = $49,240

Inspection is 100% reliable.

So, the maximum amount that would be willing to pay for the inspection process is - $49,240 which is also an overhead cost.