This case is set in 1965 in a division of a major UK-based chemicals firm when the exchange rate was $2.80/£, inflation was about 4% per year, and a chemical worker was paid about £3,000 per year. The issue is make versus buy for packaging containers. The container is technologically advanced and is an important element of the value of the end product to the customer.

The Wellington Chemicals Division manufactures and sells a range of "hard to hold" chemical products throughout Great Britain. Since these products require careful packing and storing, the company has always promoted the special properties of the containers it uses. In fact, a major element of Wellington's marketing strategy is its container. The containers are large steel drums with a unique, patented, spray-on lining made from a specialty chemical known as GHL. Each drum weighs about 260 pounds and holds about 500 gallons which is about 1.25 tons. The firm operates a department especially to maintain its containers in good condition and to make new ones to replace those that are past repair. Wellington is making 3,000 new containers each year and repairing 4,000 used containers, There are 12,000 containers in circulation (an average 4 year life) and containers average 3 round trips per year. Thus, on average, each container is used 12 times and repaired 1.33 times during its life.

Mr. Walsh, the division general manager, has for some time suspected that the firm might save money, and get equally good service, by buying its containers from an outside source. After careful inquiries, he approached a firm specializing in container production, Packages, Ltd., and asked for a quotation. At the same time, he asked Mr. Dyer, his chief accountant, to provide him with an up- to-date statement of the cost of operating the container department (see below).

 

Within a few days, the quotation from Packages, Ltd. came in. The firm was prepared to supply all the new containers required (3,000 per year) for £125,000 per year, the contract to run for a guaranteed term of five years and thereafter to be renewable from year to year. If the required number of containers increased, the contract price would be increased proportionally. Additionally, Packages Ltd. would undertake to carry out purely maintenance work on containers, short of replacement, for a sum of £37,500 per year, on the same contract terms. Walsh estimated that Packages, Ltd. would make a 15% profit margin (before taxes) on each of the contracts. They would only accept the maintenance work if they were also manufacturing the new containers.

 

Mr. Walsh compared the outsourcing bids with the cost figures prepared by Mr. Dyer, covering a year's operation of the Container Department shown above.

Wellington Chemicals Division Walsh's conclusion was that no time should be lost in closing the department and entering into the two contracts offered by Packages, Ltd. However, he felt bound to give the manager of the department, Mr. Duffy, an opportunity to question this conclusion before he acted on it. He therefore called him in and put the facts before him, at the same time making clear that Mr. Duffy's own position was not in jeopardy—even if his department were closed, there was another managerial position shortly becoming vacant to which he could be moved without loss of pay or prospects.

Mr. Duffy looked thoughtful throughout their conversation and asked for time to think the matter over. The next morning, he asked to speak with Mr. Walsh again and said he thought there were a number of considerations that ought to be borte in mind before his department was closed. "For instance," he said, "what will you do with the drum making machinery? It cost £120,000 four years ago, but you'd be lucky if you got £20,000 for it now, even though it's good for another four years at least. And then there's the stock of GHL we bought a year ago. We bought a five-year supply in order to be able to buy directly from the manufacturer and we paid £100,000. Dyer's figure of £70,000 for materials probably includes about £20,000 for GHL. We bought it for £500 a ton, but you wouldn't have more than £400 a ton left if you sold it, after you'd covered all the handling expenses."

Walsh thought that Dyer ought to be present during this discussion. He called him in and put Duffy's points to him. “I don't much like all this conjecture," Dyer said. “I think my figures are pretty conclusive. Besides, if we are going to have all this talk about what will happen if,' don't forget the problem of space we're faced with. We're paying £8,500 a year in hire purchase fees for a warehouse a few kilometers away from our plant, If we closed Duffy's department, we'd have all the space we need without that warehouse."

"That's a good point," said Walsh, "though I must say I'm a bit worried about the workers if we close the department. I don't think we can find room for any of them elsewhere in the firm. I could see whether Packages can take any of them. But some of then are getting on. There's Walters and Hines, for example. They've been with us since they left schoot 40 years ago. I'd feel bound to give them pensions--£1,500 a year each, say."

Duffy showed some relief at this. "But I still don't like Dyer's figures," he said. "What about the allocated space cost and the £22,500 for general administrative overhead? You surely don't expect to close down any space or sack anyone in the general office if I'm closed, do you?" "Probably not," said Dyer, "but someone has to pay for these costs. We can't ignore them when we look at an individual department, because if we do that with each department in turn, we shall finish up by convincing ourselves that managers, accountants, typists, stationery, and the like don't have to be paid for. And they do, believe me."

"Well, I think we've thrashed this out pretty fully," said Walsh, "but I've been turning over in my mind the possibility of perhaps keeping on the maintenance work ourselves. What are your views, Duffy?"

 

"I don't know," said Duffy, "but it's worth looking into. We shouldn't need the drum machinery for that, and I could hand supervision over to the foreman. You'd save my salary plus £3,000 a year there, say. You'd only need about 3 of the workers, but your could keep the oldest. The other 12 men are split about equally between drum- making, applying GHL to new containers, and general departmental labor. You wouldn't save any space, so I suppose the hire purchase fees would be the same. I shouldn't think the other expenses would be more than £6,500 a year." "What about materials?" asked Walsh. "We use about 10 percent of the GHL on maintenance," Duffy replied, "and not much else."

 

"Well, I've told Packages, Ltd. that I'd let them know my decision within a week," said Walsh. "Tit let you know what I decide to do before I write to them."

 

QUESTIONS

 

One common approach in analyzing a situation like this is to prepare a comprehensive, multi-year cash flows spreadsheet for the various options. This requires careful attention to differential cash flows, a relevant time frame, inflation, taxation, and time value of money. If you choose this approach, be careful in carrying it through comprehensively and in considering what inferences it will support. Assume a 40% tax rate.

 

If you choose some other cost analysis approach, be sure you are clear as to why you are not doing a multi- year spreadsheet analysis, What conclusions do you draw from your cost analysis?

 

What recommendation would you make to Mr. Walsh? Why?

Materials (mostly steel and GHL) Labor 70,000 5,000 45,000 Foreman Workers Department Overheads Manager's Salary Allocated space costs on 8,000 Container Dept. Facility Depreciation of Drum Machinery Maintenance of Drum Machinery Other Expenses 4,500 15,000 3,600 15.750 46.850 166,850 22,500 Allocated Share of Administrative Overheads Total Cost of Department for One Year 189.350