Last week Charlie had a call from Ed Spencer, the owner of Spencer's Furniture Shop, a local retailer of unfinished furniture. Spencer deals exclusively in fully assembled, unfinished furniture; customers can apply whatever finish they want so the items they buy will match an existing color scheme. The Spencer suggested that he display and sell unfinished models of Charlie's chairs. Charlie would avoid the commission to the dealer. Spencer is willing to give Charlie $160 per chair. This would be a sale to Spencer, who would then take his own commission off whatever he sold the chairs for. Charlie figures he would save "about $10.00" per unit in stain, lacquer, and related supplies. He also noted that, for any given chair, about 60% of his time is spent in cutting the wood and assembling and gluing the pieces together. The rest of the time is spent on finishing the chairs.

Charlie likes the idea of another outlet for this products, but he is not sure whether this is a good deal not What should he do? Assume that the present arrangement with the antiques dealer does not preclude this sort of agreement with Spencer's, and that Charlie would be able to meet whatever production demands were involved. What should he do? [Hint: If this initially sounds like a good deal, think through the ramifications of a dramatic increase in demand arising from this arrangement.] Answer

Charlie would save $10.00 on finishing materials, and his labor would be reduced as well. He spends 40% of his time on finishing, so the pro-rata labor cost of finishing is $36.00 [40% * $90 = $36]. Therefore the total cost savings is $10 + $36 or $46.00. Under the original assumptions, total variable manufacturing costs are $162.50. If these are reduced by $46.00, the new variable manufacturing costs would be $116.50, which is less than the $160 Spencer is offering him. So far, this sounds like a good deal.

There IS a catch, however. There is no indication how long this arrangement would last, and we are assuming that there would be adequate production capacity. What would happen if demand "took off" as a consequence of this deal? Here's where the short run/long run implications of this kind of arrangement really come into play. The table shows what happens to the average total cost per chair [assuming 100% of production is sold through Spencer].

Note that the average total cost per chair doesn't get down to $160 until Charlie hits 11 or 12 chairs per month. Stated differently, even with the $46.00 reduction in variable costs, a sales price of $160.00 each doesn't even come close to covering costs until Charlie's output is considerably higher than he expects it to be. Consequently, this is a good deal only in the short run--a one time arrangement for a relatively small number of chairs--4 or 5, maybe. However, as he sells more to Spencer under this arrangement, he'll have to sell disproportionately more at the regular price to compensate for the lost margin. As an ongoing proposition, forget it!

 

 

 

 

Copyright © 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.

Last modified: August 03, 2005