Vosilo has just received a report indicating that GianAuto could purchase the entire annual output of Denver Cover from outside suppliers for $30 million. Vosilo was astonished at the low outside price because the budget for Denver Cover’s operating costs for the coming year was set at $52 million. Vosilo believes that GianAuto will have to close down operations at Denver Cover in order to realize the $22 million in annual cost savings.
The budget for Denver Cover’s operating costs for the coming year is presented on the following page. Additional facts regarding plant operations are as follows:
a.
Due to Denver Cover’s commitment to use high-quality fabrics in all its products, the purchasing department was instructed to place blanket purchase orders with major suppliers to ensure the receipt of sufficient materials for the coming year. If these orders were canceled as a consequence of the plant closing, termination charges would amount to 20 percent of the cost of direct materials.
b.
Approximately 800 plant employees will lose their jobs if the plant is closed. This includes all of the direct laborers and supervisors as well as the plumbers, electricians, and other skilled workers classified as indirect plant workers. Some would be able to find new jobs while many others would have difficulty. All employees would have difficulty matching Denver Cover’s base pay of $9.40 per hour that is the highest in the area. A clause in Denver Cover’s contract with the union may help some employees; the company must provide employment assistance to its former employees for 12 months after a plant closing. The estimated cost to administer this service would be $1.5 million for the year.
c.
Some employees would probably elect early retirement because GianAuto has an excellent pension plan. In fact, $3 million of the 2005 pension expense would continue whether Denver Cover is open or not.
d.
Vosilo and his staff would not be affected by the closing of Denver Cover. They would still be responsible for administering three other area plants.
e.
Denver Cover considers equipment depreciation to be a variable cost and uses the units-of-production method to depreciate its equipment; Denver Cover is the only
2
GianAuto plant to use this depreciation method. However, Denver Cover uses the customary straight-line method to depreciate its building.
DENVER COVER PLANT
Budget for Operating Costs
For the Year Ending December 31, 2005
Materials $14,000,000
Labor
Direct $13,100,000
Supervision 900,000
Indirect plant 4,000,000 18,000,000
Overhead
Depreciation-equipment 3,200,000
Depreciation-building 7,000,000
Pension expense 5,000,000
Plant manager and staff 800,000
Corporate allocation 4,000,000 20,000,000
Total budget costs $52,000,000
REQUIRED:
1.
Without regard to costs, identify the advantages to GianAuto Corporation of continuing to obtain covers from its own Denver Cover Plant.
2.
GianAuto Corporation plans to prepare a dollar analysis that will be used in deciding whether or not to close the Denver Cover Plant. Management has asked you to identify:
a.
The recurring annual budgeted costs that are relevant to the decision regarding closing the plant (show the dollar amounts).
b.
The recurring annual budgeted costs that are not relevant to the decision regarding closing the plant, and explain why they are not relevant (again show the dollar amounts).
c.
Any nonrecurring costs that would arise due to the closing of the plant, and explain how they would affect the decision (again show any dollar amounts).
3.
Looking at the data you have prepared in (2), should the plant be closed? Show computations, and explain your answer.
4. Identify any revenues or costs not specifically mentioned in the problem that GianAuto should consider before making a decision
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