Wellington Chemicals Division
Teaching Commentary
OVERVIEW
This case deals with one of the classic managerial decisions—make versus buy.
Most courses in managerial
accounting include at least one “make/buy” problem to illustrate the applicability of “relevant cost analysis” in
thinking about such decisions.
This case is rich enough to support a fully-articulated “relevant cost” analysis. It also will support a
“strategic” analysis with a little more digging by the students.
It is a great case to illustrate different cost analysis frameworks for a classic management decision.
CASE ANALYSIS
The following list includes intermediate calculations/estimates which can be derived either from the case or
from some basic library research. At Tuck, I expect the students to be able to derive items such as these on their
own. Some instructors prefer to make this list available to students along with the case to simplify the assignment.
1.
2.
3.
4.
5.
6.
In 1965, the exchange rate was $2.80/£.
A worker is probably making about £3,000/year.
- A £1,500 pension at about 50% of regular pay
- The foreman makes £5,000, and a worker would be about 50% to 75% of that
- A US chemicals worker made about $7,000 (before fringes) in 1965 = ~£2,500
Thus, the workforce is about 15 people (£45,000 ÷ £3,000).
Wellington uses 40 tons of GHL per year (100,000/£500 per ton = 200 tons ÷ 5 years = 40).
Wellington uses 36 tons of GHL to make new containers (90%). This is 24 pounds per container.
How large are the containers?
Steel Cost = £50,000 (70,000 - 20,000)
In 1965, basic steel cost $360/ton in the U.S.
This is about 390 tons of steel (£50,000  2.8 = $140,000 ÷ $360/ton)
For 3,000 new containers, this is ~260 pounds per container, which is pretty big
A standard 55 gallon drum weighs about 30 pounds
Thus each drum holds probably about 500 gallons
This teaching commentary was prepared by Professor John K. Shank of the Amos Tuck School of Business.
35-1
7.
Since the Packages Ltd. price of £41.67 (£125,000
÷ 3,000) is fixed for 5 years, there must be an
inflation factor included.
At ~4% inflation,
Packages is really charging about £38 the first year,
with a 5-year trend of about 38, 40, 42, 44, 46.
8.
At about 5 pounds per gallon (conversion factor),
each drum holds about 1.25 tons of whatever
chemical Wellington is selling.
9.
If the current GHL price of £600/T is typical for
specialty chemicals, the sales value of one drum
full of chemicals is about £750.
10. It is not clear how Administrative Overheads are
allocated, but £22,500 is 50% of hourly labor.
Allocation based on direct labor would have been
very typical in 1965.
11. The cost at Wellington for “maintenance only” is
as follows, per Duffy’s estimates:
Manager
Foreman
Workers
45,000)
GHL
20,000)
Other Expenses
Space Costs
Overhead Allocation
0
5,000 (Same)
9,000 (20%

2,000 (10%

6,500 Per Duffy
4,500 Same
4,500 (50%  9,000)
£31,500
Options
1
Make
Both
÷ 3,000), fully absorbed. This compares to the
“buy” cost of ~£38 (point #7) in 1965.
13. The drums are re-used many times, according to
the case, with regular maintenance. Since each
drum is used 12 times, on average, the cost per use
is only about £4.4, which is less than 1% of the
value of the contents (estimated at £750).
Taking a very simple view of the problem, the
following series of arguments can be made:
Level 1 We make everything that is important because
that is the only way to maintain full control.
Level 2 Buying is cheaper (£189,350
£162,500), so outsource if possible.
versus
Level 3 On an incremental cost basis, making is
cheaper (£162,500 versus £147,350 [£189,350
less depreciation of £15,000 and less allocated
costs of £4,500 and £22,500]), so do not
outsource.
A more sophisticated analysis would consider
multi-year cash flows, taxes, tax shields, inflation and
the time value of money over some relevant planning
horizon. Such an analysis is presented below using a
four-year horizon—the remaining life of the equipment
and the GHL inventory.
2
Make Containers
Buy Maint.
3
Buy Containers
Make Maint.
4
Buy
Both
A. Costs Not Relevant
Allocated Space Cost
Allocated Overhead
Depreciation
GHL
B. 4 Year Total Cash Flows (000)
Materials (steel only)
Workers
Foreman
Manager
Other Expenses
Machinery Maintenance
Purchase Contract
Sale of GHL
Sale of Equipment
Saved Outside Rent
Net
200
180
20
32
63
14.4
0
0
0
____
509.4
12. Each new drum thus costs £52.6 (189,350 - 31,500
35-2
200
144
20
32
37
14.4
150
(6.4)
0
____
591
4,500
22,500
15,000
20,000
0
36
20
0
26
0
500
(57.6)
(20)
____
504.4
0
12
0
0
0
0
650
(64)
(20)
(34)
544
C. Fold in Tax Considerations
1.
2.
3.
4.
Options 1 and 2 are enhanced by the shelter from 15,000 depreciation per year. [15,000  .4 = 6,000.]
There is also tax shelter from the GHL which is a noncash charge. [8,000 for option 1 (20,000  .4), 7,200
for option 2 and 800 for option 3.]
All the operating cash flows are only 60% as high, after taxes.
Losses on Sale of Machinery and GHL create tax savings in year 1:
Book Value
Salvage
Book Loss
Tax Saved (40%)
GHL
Machinery
80
(64)
16
6.4
60
(20)
40
16
1
509.4
306
(32)
(24)
---250
2
597.4
358.4
(28.8)
(24)
(.6)
-(6.4)
298.6
D. After Tax 4 Year Cash Flows
As Above (recurring items)
 .6
+ GHL Shelter
+ Machinery Shelter
+ Tax Saved on GHL Sale
+ Tax Saved on Equip. Sale
+ Salvage Value
35-3
3
582
349.2
(3.2)
-(5.8)
(16)
(77.6)
246.6
4
628
376.8
--(6.4)
(16)
(84)
270.4