(a) Sniff should consider the following factors when making a further processing decision.

– Incremental revenue. The new perfume, once further processed, should generate a higher price and the extra revenue is clearly relevant to the decision.

– Incremental costs. A decision to further process can involve more materials and labour. Care must be taken to only include those costs that change as a result of the decision and therefore sunk costs should be ignored. Sunk costs would include, for example, fixed overheads that would already be incurred by the business before the further process decision was taken. The shortage of labour means that its ‘true’ cost will be higher and need to be included.

– Impact on sales volumes. Sniff is selling a ‘highly branded’ product. Existing customers may well be happy with the existing product. If the further processing changes the existing product too much there could be an impact on sales and loyalty.

– Impact on reputation. As is mentioned in the question, adding hormones to a product is not universally popular. Many groups exist around the world that protest against the use of hormones in products. Sniff could be damaged by this association.

– Potential legal cases being brought regarding allergic reactions to hormones.

(b) Production costs for 1,000 litres of the standard perfume

$

Aromatic oils 10 ltrs x $18,000/ltr                         180,000

Diluted alcohol 990 ltrs x $20/ltr                          19,800

                                                     ––––––––

Material cost                                          199,800

Labour 2,000 hrs x $15/hr                                30,000

––––––––

Total                                                 229,800

––––––––

Cost per litre 229·80

Sales price per litre 399·80

Lost contribution per hour of labour used on new products

($399,800 – $199,800) ÷ 2,000 hrs = $100/hr

Incremental costs

Male version                  Female version

$                            $

Hormone                2 ltr x $7,750/ltr          15,500     8 ltr x $12,000/ltr     96,000

Supervisor Sunk cost                               0         Sunk cost             0

Labour                 500 hrs x $100/hr         50,000      700 hrs x $100/hr     70,000

Fixed cost Sunk cost                                0         Sunk cost             0

Market research Sunk cost                           0         Sunk cost            0

                                              –––––––                    –––––––––

Total                                          65,500                        166,000

Incremental revenues

Male version                      Female version

$                                 $

Standard           200 ltr x $399·80/ltr       79,960        800 ltr x $399·80        319,840

Hormone added     202 ltr x $750/ltr         151,500        808 ltr x $595/ltr        480,760

––––––––                           ––––––––

Incremental revenue                         71,540                            160,920

––––––––                           ––––––––

Net benefit/(cost)                             6,040                             (5,080)

The Male version of the product is worth further processing in that the extra revenue exceeds the extra cost by $6,040.

The Female version of the product is not worth further processing in that the extra cost exceeds the extra revenue by $5,080.

In both cases the numbers appear small. Indeed, the benefit of $6,040 may not be enough to persuade management to take the risk of damaging the brand and the reputation of the business. To put this figure into context: the normal output generates a contribution of $170 per litre and on normal output of about 10,000 litres this represents a monthly contribution of around $1·7m (after allowing for labour costs).

Future production decisions are a different matter. If the product proves popular, however, Sniff might expect a significant increase in overall volumes. If Sniff could exploit this and resolve its current shortage of labour then more contribution could be created. It is worth noting that resolving its labour shortage would substantially reduce the labour cost allocated to the hormone added project. Equally, the prices charged for a one off experimental promotion might be different to the prices that can be secured in the long run.

(c) The selling price charged would have to cover the incremental costs of $166,000. For 808 litres that would mean the price would have to be ($166,000 + $319,840)/ 808 ltrs = $601·29/ltr or about $60·13 per 100 ml. This represents an increase of only 1·05% on the price given and so clearly there may be scope for further consideration of this proposal.

(d) Outsourcing involves consideration of many factors, the main ones being:

–  Cost. Outsourcing often involves a reduction in the costs of a business. Cost savings can be made if the outsourcer has a lower cost base than, in this case, Sniff. Labour savings are common when outsourcing takes place.

–  Quality. Sniff would need to be sure that the quality of the perfume would not reduce. The fragrance must not change at all given the product is branded. Equally Sniff should be concerned about the health and safety of its customers since its perfume is ‘worn’ by its customers

–  Confidentiality. We are told that the blend of aromatic oils used in the production process is ‘secret. This may not remain so if an outsourcer is employed. Strict confidentiality should be maintained and be made a contractual obligation.

–  Reliability of supply. Sniff should consider the implications of late delivery on its customers.

–  Primary Function. Sniff is apparently considering outsourcing its primary function. This is not always advisable as it removes Sniff’s reason for existence. It is more common to outsource a secondary function, like payroll processing for example.