QwakSoda Corporation makes soda in three departments: blending, bottling, and labeling.
Currently, the output from the blending department first moves through the bottling department
and then through the labeling department before it is sold to retail distributors for $150 per 100
bottles. QwakSoda provides the following information:
Bottling Labeling
Monthly capacity (in bottles) 70,000 80,000
Monthly production (in bottles) 67,200 63,840
Direct material costs per 100 bottles 50 5
Fixed operating costs $50,000 $40,000
Although QwakSoda, currently, has no production constraints in the blending department, it can
start with only 70,000 bottles in the bottling department because of the capacity constraints of the
machines. Of the 70,000 bottles produced in the bottling department, 2,800 (4%) defective
bottles are scrapped at zero net disposal value. The good bottles from the bottling department are
sent to the labeling department. Of the 67,200 good bottles started at the labeling operation,
3,360 (5%) defective bottles are scrapped at zero net disposal value. QwakSoda Corporation’s
total monthly sales of bottles equals the labeling department’s output.
Required:
1. The labeling department is considering buying 15,000 bottles to label from an outside supplier at
$75 per 100 bottles, which is much higher than QwakSoda’s cost to manufacture the bottles. The
labeling department expects that 10% of the bottles obtained from the outside supplier will result
in defective products. Should the labeling department buy the bottles from the outside supplier?
Show your calculations.
2. QwakSoda’s engineers have developed a method that would lower the labeling department’s rate
of defective products to 2.5% at the labeling operation. Implementing the new method would
cost $1,500 per month. Should QwakSoda implement the change? Show your calculations.
3. The design engineering team has proposed a modification that would lower the bottling
department’s rate of defective products to 1.5%. The modification would cost the company $200
per month. Should QwakSoda implement the change? Show your calculations.
SOLUTION
(45–50 min.) Quality improvement, theory of constraints.
1. Consider the incremental revenues and incremental costs to QwakSoda’s cost of
purchasing additional bottles to label.
Incremental Revenues ($150×(15,000×0.9/100)) 20,250
Incremental Costs
Cost of Materials (15,000/100×$75) 11,250
Cost of Material at labeling ((15,000×0.9)/100)×$5 675
Incremental Costs 11,925
Excess of incremental revenues over incremental costs 8,325
Note that as the Labeling department has surplus capacity equal to 16,160 (80,000 –
63,840) bottles per month, purchasing bottles from outside entails zero opportunity costs. Yes,
the Labeling Department should buy the bottles from the outside supplier.
2. By producing 100 defective bottles in the Bottling process, QwakSoda Corporation is
worse off by the entire amount of revenue forgone of $150 per 100 bottles. The bottling
operation is a constraint, so the labeling department is limited by the number of bottles it
receives from the Bottling Department. As a result, any bottles received by the Labeling
Department that are defective and disposed of at zero net disposal value result in lost revenue to
the firm.
An alternative approach to analyzing the problem is to focus on the costs of defective
units and the benefits of reducing defective units.
The relevant costs of defective units in the Labeling Department are as follows:
Direct Materials variable costs in bottling department 50
Direct Materials variable costs in labeling department
Contribution margin foregone from not selling 100 bottles 95
($150-$50-$5)
Amount by which QwakSoda is worse off as a result of a 150
defective unit (100 bottles) in the Labeling department
Note that only the variable costs of defective units of $55 per 100 bottles (direct materials in the
Bottling Department, $50: direct materials in the Labeling Department, $5) are relevant because
improving quality will save these costs. Fixed costs of producing defective units, attributable to
other operating costs, are irrelevant because these costs will be incurred whether QwakSoda
Corporation reduces defective units in the Labeling Department or not. In addition, there is an
opportunity cost of contribution margin forgone as a result of producing a defective unit in the
Labeling Department because it results in lost revenue.
QwakSoda Corporation should make the proposed modifications in the Labeling
Department because the incremental benefits exceed the incremental costs by $1,020 per month:
Incremental benefits of reducing defective units in
the
Labeling department by 2.5% (from 5% to 2.5%)
2.5%×(67,200/100)×$150 (computed above) 2,520
Incremental costs of improvements 1,500
Excess of incremental benefits over incremental costs 1,020
