Perry & Paul, LLP

To:
Date:

Mike Lewis, Plant Manager

June 4, 1990

From:
Subject:

Ronald Perry, Senior Partner

Outsourcing of manifolds

I.
Introduction
It has been about two weeks since we discussed the possibility of outsourcing the production of manifolds at the
Automotive Component & Fabrication Plant (ACF). My office has since exerted great effort in our investigation of the
ACFs concerns, as it is our mission to reach the strategic decision that will best help our clients in achieving future goals.
We have carried out the procedures necessary for gaining an understanding of the ACFs cost system, as well as any
additional matters that may affect the facilitys production costs. I present you with the results of our investigation and, as
a conclusion, offer you my recommendation as to whether the ACF should outsource its production of manifolds.
II.

Investigation & Analysis

i. Background and Key Issues

In order to decide upon a suitable strategy for the ACF, we began by reviewing the companys recent historyin
particular, the circumstances that have led to the facilitys current state of uncertainty. Firstly, it is important to note that
the ACF is a key manufacturer of components for leading automobile producers in the U.S. The ACFs competition,
which once was limited to domestic suppliers, has rapidly increased since 1985, as a major paradigm shift is taking place
within the industry. In particular, rising gasoline prices and higher foreign competition have led to significant losses of
market share for the domestic automobile sector. As a result, the ACF and its competitors must vie for a smaller number
of production contracts, thereby reducing the facilitys sales volume. The dynamics of the automobile industry have been
particularly volatile for the ACF in the previous few years, as the facility was forced to close down several of its plants.
To combat the trend of decreased market share, the ACF devised a plan several years ago that involved analyzing
their product lines and outsourcing those that fell significantly below the world-class standard. As a result, the facility
recently outsourced its production of mufflers and oil pans, while also making labor improvements in an effort to match
the world-class production efficiency of its foreign competition. Despite these efforts, the ACF continues to fall behind
its competition and lose market share to foreign competitors. Currently, the ACF must decide whether to outsource its line
of manifolds, which have recently received a major downgrade in classification. Yet the prospect of increased emission
standards, which would drive up the demand and price for the ACFs manifolds, has compelled the facility reach a
decision more cautiously, as a premature disposal of the product line may result in a forgoing of higher sales and profit.
ii. Allocation of Manufacturing Overhead at the ACF
During my analysis of the ACFs cost system, I discovered that the plant relies on a single cost driverthe cost of direct
laborto allocate its overhead to products. Knowing this, I was able to calculate the plants budgeted overhead allocation
rate (Exhibit 1) for the past four years. There was a minor overhead variance in 1987, when the ACF had an overapplied
overhead: the actual overhead rate was 435%, while the predetermined rate, which was used to calculate the plants
applied overhead, was 437%. The variance reflects that the cost of direct hours was too high to apply overhead correctly;
however, the small difference between the two rates is typical for a system that relies on estimates.
Between 1987 and 1988, the ACF did not experience any major changes in its budgeted direct labor and overhead;
as a result, the shift in the overhead rate between those years was relatively insignificant. However, in stark contrast, the
overhead rate rose by almost one third between 1988 and 1989. These changes are mainly attributed to the facilitys
decision to outsource oil pans and mufflers, as sixty direct labor jobs and thirty indirect labor jobs were lost in the process.
Given that the overhead allocation rate is driven by the cost of direct labor, the loss of these jobs directly impacted the
overhead allocation rate. Furthermore, although budgeted sales fell by nearly forty percent with the decrease in
production, the facilitys overhead costs did not decline at the same degree, falling by almost 30 percent. This
discrepancy likely resulted because of the overhead accounts inclusion of fixed costs, which remain relatively constant at
expected levels of production activity. Yet since the ACF was functioning below its typical range of activityas

Perry & Paul, LLP

exemplified by its reduction of indirect laborcosts that once were considered fixed likely declined as well, although not
as sharply as the variable costs that fell directly with the decrease in production.
Between 1989 and 1990, the overhead rate decreased, but to a much lesser extent than the previous year, as direct
labor and overhead costs remained relatively stable. Furthermore, whereas sales rose by nearly 5%, the facilitys
overhead only increased by about 1.6%. While fixed costs within overhead contribute to this difference, efforts to
increase workers efficiency also likely were a factor. For example, the labor time to change dies improved from twelve
hours to ninety minutes, while workers uptime increased from 30% to 65%. Such improvements helped reduce costs
incurred by both direct and indirect labor.
In order to ascertain the effects of the ACFs decision to outsource mufflers and oil pans, I calculated the
expected gross margins of two hypothetical products using the facilitys 1988 and 1990 budgets (Exhibits 2 and 3). The
nearly 30% increase in the ACFs overhead allocation rate would have drastic effects on the gross margins of these
products, which respectively decreased by 55% and 35%, due to the added overhead burden. Although the ACF was able
to outsource substandard products and thereby reduce operating costs, it also negatively impacted the gross margins of its
products, which had to carry additional fixed costs (as highlighted by the increased overhead rate).
iii. Cost System Deficiencies
After a careful investigation of the ACFs allocation of overhead, it became clear to us that the facility is not operating
under an appropriate cost system, especially in regard to strategic decision making. In particular, the facilitys use of
single cost driverdirect labor costhas been impeding its ability to accurately allocate budgeted overhead, as one input
cannot drive the costs of all overhead accounts (for example, Account 8000, which is depreciation on machinery).
Furthermore, direct labor itself has limitations as a cost driver, since a significant portion of the facilitys activities are
carried out by machinery (which in turn increases the ACFs overhead, increasing its significance to the facilitys budget).
The use of machinery causes direct labor to decline in importance as a productive input and, as a result, it becomes less
appropriate as a cost driver. Therefore, if the ACF is inappropriately allocating its overheadwhich makes up a large
proportion of total production costsit likely cannot arrive at appropriate strategic decisions, as demonstrated by the
seemingly unwise decision to outsource products and consequently experience sharp decreases in gross margins.
iv. Estimated Model Budgets
In order to determine if the ACF should outsource its production of manifolds, we estimated its 1991 model budget under
two scenarios: the continued production of manifolds and the outsourcing of manifolds. Under the first set of
circumstances, which also assume that selling prices, volumes, and material costs remain the same, we determined that the
1991 budget would be identical to that of 1990 (Exhibit 4).
However, if the manifold is outsourced and the same variables (s elling prices, volumes, and material cost)
remain the same, there will be several items affected on the 1991 model budget (Exhibit 5). Firstly, we would drop all
direct material and direct labor costs for manifolds, as they would no longer be incurred. We would also lose any sales
corresponding to the production of manifolds. Furthermore, we must account for the overhead costs that are currently
allocated to manifolds, and either allocate them appropriately to the other products or consider them avoidable costs, as
they were indirectly related to the manifolds to some extent. In order to properly perform this analysis, we must
determine which costs are fixed and which are more variable compared to the output of manifolds.
Stainless steel exhaust manifolds are produced in a highly automated production process: the parts are loaded on
fixtures and robotically welded. Therefore, there are many more costs associated with machinerysuch as those incurred
by the engineers that use them, set ups, repairs, and spare partsthan the costs associated with the production laborers.
Since direct labor is used to allocate the overhead costs to products, we looked at the specific costs as a percentage of
direct labor to estimate how many overhead costs would be incurred if the ACF outsourced production of manifolds
(Exhibit 6).

1000 - Wages and benefits for non-skilled hourly labor decreased by $2,234 after the previous products were
dropped, meaning some of the costs were relative to the products. Looking at the percentage of direct labor. It
increased from 30.86% to 41.16% after the other products were dropped, meaning that some of the costs were
unavoidable. I estimate that the percentage of direct labor would be increased to 45%,
1500 Many salaried plant workers would remain as the manifolds are produced in a mostly automated fashion
and plan workers are not needed to work the machines. Removal of manifolds would increase percentage of
direct labor to 50% from 42.04% as the plant workers would still be needed for the other products.

Perry & Paul, LLP

2000 These production supplies are used on all products and are not very specific. Overhead to labor
percentage remained constant even through the outsourcing of the other two products. Therefore the outsourcings
of manifolds at 15% of direct labor will remain at that number.
3000 The small wearing tools are used on all products and are not very specific. Overhead to labor percentage
remained constant even through the outsourcing of the other two products. Therefore the outsourcings of
manifolds at 10% of direct labor will remain at that number.
4000 Some of the utilities would be avoided such as coal used in the manifolds production machines but others
would remain, thereby increasing percentage of direct labor from 52% to 60%.
5000 Some of the nonproduction employees costs that are used for plant maintenance could be avoided by
dropping but the manifolds as they would not be needed for maintenance on the equipment. Some costs would
still remain as many of them would still be needed for the other products. Therefore, percentage of direct labor
would increase from 144% to 160%.
8000 Depreciation costs would remain constant as the machines that are being used by the company currently
for manifolds would be sold therefore removing that depreciation cost. The percentage would increase a bit, due
to the loss of direct labor cost from manifolds from 27% to 30%.
9000 The various personnel costs would not be affected as much by the loss of the manifolds production as
there are not many employees involved with producing them as it is a largely automated procedure. Therefore
percentage of direct labor would increase from 42% to 50%.
11000 The project expense for the one time machine set up would be avoided as they would sell off the
equipment. The percentage would increase a bit, due to the loss of direct labor cost from manifolds from 22% to
25%.
12000 - These employee benefits are directly related to direct labor and therefore will decrease accordingly as
manifolds are no longer produced. Overhead to labor percentage remained constant even through the outsourcing
of the other two products. Therefore the outsourcings of manifolds at 111% of direct labor will remain at that
number.
14000 The benefits for the skilled workers directly related to the ones in 5000 category. In the same respect,
most of these costs will remain as manifolds are a mostly automated process. Therefore, the percent of direct
labor will increase from 57% to 70%.
Using these overhead costs as part of our analysis, we determined that the ACFs total profit would be $44,700 in 1991 if
manifolds were outsourced; on the other hand, if the ACF continues production of manifolds, its profit would be $63,501.
Furthermore, if the ACF continues producing manifolds, its overhead allocation rate would be 563%, which is the same as
the 1990 rate; in contrast, the allocation rate would increase to 626% if the facility outsources its production of manifolds.

III.
Recommendation
Our investigation of the ACFs cost system has revealed that it cannot currently be used for strategic decision making.
However, our office was able to gain a more accurate understanding of the facilitys cost structure through a detailed
analysis of its overhead accounts. As a result, we can confidently recommend the ACF to not outsource its production of
manifolds, on account of several major concerns. Firstly, sales of manifolds are absorbing a significant amount of
overhead costs; on the other hand, if the ACF outsources manifolds, a portion of this burdenthat is, fixed overhead costs
would be shifted to remaining products (as highlighted by the expected increase in allocation rate from 563% to 626%).
With additional burden, the gross margins of these remaining products would decrease, thereby driving down the ACFs
total profit as well. Although outsourcing reduces some of the ACFs operational costs, it cannot decrease fixed overhead
costs sufficiently, resulting in these negative financial effects. Furthermore, the facility has to consider that the market for
stainless steel manifolds may suddenly increase, presenting the ACF with potentially higher profits if it continues to
produce manifolds.
In addition to experiencing financial drawbacks, the ACF may also witness a significant drop in employee morale
if it outsources its production of manifolds, as doing so would result in a loss of jobs. Furthermore, employees may be led
to question their efforts to improve uptime and productivity, as manifolds would be outsourced regardless of such
improvements. If workers cease these efforts, the ACF may incur additional costs in both direct labor and overhead.

Perry & Paul, LLP

Before making a final decision, however, the ACF should conduct further market research and perhaps solicit
buyers for future order quantities and dates, as doing so may result in significantly more accurate budgeting. A market
survey may further reveal the actual potential for an increase in demand of stainless steel manifolds, which pose a large
growth opportunity for the ACF.
Finally, I strongly recommend that the
ACF explore activity-based cost
systems, as they are far more accurate
than the use single cost driver.
Since overhead costs make up a large
portion of the facilitys total costs,
it is especially crucial to trace these costs
Exhibit 1:
to their appropriate source. In
fact, doing so may reveal that another
product should be outsourced,
Overhead Allocation Rates
rather than manifolds. The ACF will be
much more able to achieve its
future goals if it can make strategic
decisions using an improved cost
system.
Year

1987
1988
1989
1990

Rate (% of Direct
Labor Cost)
437%
434%
577%
563%

Exhibit 2:

Exhibit 3:

Expected Gross Margin of

Product 1

Expected Gross Margin of

Product 2

Selling Price
Material Cost
Labor Cost
Overhead
Cost
Profit
Gross Margin
Change in
Gross Margin

1988
$62
$16
$6

1990
$62
$16
$6

$26.04

$33.78

$13.96
22.52
%

$6.22

10.03%
-55.46%

Selling Price
Material Cost
Labor Cost
Overhead
Cost
Profit
Gross Margin
Change in
Gross Margin

1988
$54
$27
$3

1990
$54
$27
$3

$13.02

$16.89

$10.98
20.33
%

$7.11

13.17%
-35.22%

Perry & Paul, LLP

Perry & Paul, LLP

Exhibit 4:
1991 Model Year Budget ($ 000), with Production of
Manifolds

Sales
Tanks
Manifolds
Doors
Muffler
Oil pans
TOTAL
Direct Materials
Tanks
Manifolds
Doors
Muffler
Oil pans
TOTAL
Direct Labor
Tanks
Manifolds
Doors
Muffler
Oil pans
TOTAL
Overhead
1000
1500
2000
3000
4000
5000
8000
9000
11000
12000
14000
Total
Overhead Allocation
Rate
Profit

83,535
93,120
49,887
0
0
$226,542
16,996
35,725
16,825
0
0
$69,546
4599
6540
2963
0
0
$14,102
5679
5928
2115
1410
7433
20,274
3744
5987
3030
15683
8110
$79,393
563%
$63,501

Perry & Paul, LLP

Exhibit 5:
1991 Model Year Budget ($ 000), with Outsourcing
of Manifolds

Sales
Tanks
Manifolds
Doors
Muffler
Oil pans
TOTAL
DM
Tanks
Manifolds
Doors
Muffler
Oil pans
TOTAL
DL
Tanks
Manifolds
Doors
Muffler
Oil pans
TOTAL
Overhead
1000
1500
2000
3000
4000
5000
8000
9000
11000
12000
14000
Total
Overhead Allocation
Rate
Profit

83,535
0
49,887
0
0
$133,422
16996
0
16,825
0
0
$33,821
4599
0
2963
0
0
$7562
3402.90
3781
1134.30
756.20
4537.20
12,099.2
0
2268.60
3781
1890.50
8393.82
5293.40
$47,338.
12
626%
$44,701

Perry & Paul, LLP

Exhibit 6:
Allocation Rate (% of Direct Labor Cost) for Individual Overhead Accounts

1000
Overhead Allocation
Rate
1500
Overhead Allocation
Rate
2000
Overhead Allocation
Rate
3000
Overhead Allocation
Rate
4000
Overhead Allocation
Rate

7713
31.25
%
6743
27.32
%
3642
14.76
%
2428
9.84%
8817
35.72
%

7806
30.86
%
6824
26.98
%
3794
15.00
%
2529
10.00
%
8888
35.14
%

5572
41.16
%
5883
43.46
%
2031
15.00
%
1354
10.00
%
7360
54.37
%

5679
40.27
%
5928
42.04
%
2115
15.00
%
1410
10.00
%
7433
52.71
%

5000
Overhead Allocation
Rate
8000
Overhead Allocation
Rate
9000
Overhead Allocation
Rate
11000
Overhead Allocation
Rate

24181
97.97
%
5964
24.16
%
6708
27.18
%
5089
20.62
%

24460
96.70
%
5946
23.51
%
6771
26.77
%
5011
19.81
%

20063
148.2
1%
3744
27.66
%
5948
43.94
%
3150
23.27
%

20274
143.7
7%
3744
26.55
%
5987
42.45
%
3030
21.49
%

12000
Overhead Allocation

26936
109.1

28077
111.0

15027
111.0

15683
111.2

3402.9
45.00
%
3781
50.00
%
1134.3
15.00
%
756.2
10.00
%
4537.2
60.00
%
12099.
2
160.00
%
2268.6
30.00
%
3781
50.00
%
1890.5
25.00
%
8393.8
2
111.00