Reference no: EM131661438

Question - Foreign versus domestic production and comparative advantage

Scott Mills was originally a producer of fabrics, but several years ago intense foreign competition led management to restructure the entity as a vertically integrated cotton garment manufacturer. Scott purchased spinning entity that produce raw yarn and fabricators that produce the final garment. The entity has both domestic and international operations.

The domestic spinning and knitting operations are highly automated and use the latest technology. The domestic operations are able to produce cotton fabric for $1.52 per kilogram. The domestic fabricating operations are located exclusively in rural areas. Their locations keep total average labour costs to $16.40 per hour (including fringe benefits). The cost to ship products to the firm's distribution centre is $0.10 per kilogram.

The entity's foreign subsidiary is a fabricating operation located in the Maldives, a group of islands near India. The average wage rate there is $0.70 per hour. The subsidiary purchases cotton fabric locally for $1.60 per kilogram. The finished products are shipped to Scott Mills' distribution centre in New South Wales at a cost of $1.80 per kilogram. Both the domestic and foreign subsidiary use the same amount of fabric per product. Scott Mills has been producing three products for the private label market: sweatshirts, dress shirts, and lightweight jackets. In the past the firm processed a new order at whichever fabricating plant had the next available capacity. However, projections for the next few years indicate that orders will far exceed capacity. Management wants each plant to specialise in one of the products.

The plants are constrained by the amount of sewing time available in each. The domestic plant has 8000 hours of sewing machine time available per week, while the foreign subsidiary has 10 000 hours available per week. The domestic plant's variable overhead is charged to products at $4 per machine hour, while the subsidiary's variable overhead averages $1 per machine hour.

The windcheaters require 1 kilogram of cotton fabric to produce, the dress shirts use 400 grams of fabric, and the jackets require 1 kilogram of fabric. The domestic plant has special-purpose equipment that allows workers to sew a sweatshirt in 6 minutes, a shirt in 15 minutes, and a jacket in one hour. The foreign plant's equipment constrains production to five sweatshirts per hour, three dress shirts per hour, or two jackets per hour. The wholesale prices are $8.76 each for the sweatshirts, $7.50 for the dress shirts, and $37 for the jackets.

Required

(a) Using only quantitative information, should the firm close its domestic operations and expand the foreign subsidiary?

(b) Assuming that wages in the domestic operations remain constant, at what level of wages in the foreign subsidiary would the managers be indifferent between producing sweatshirts at one location versus the other?

(c) Discuss qualitative factors, including ethical issues, that might influence the decision in part (a).

(d) Discuss whether production quality is likely to be a bigger concern for products produced at the foreign subsidiary versus products produced in the domestic operation.

(e) If demand for each product exceeds capacity, in which product should each plant specialise?

(f) Management insists on manufacturing all three products to maintain good customer relations. If demand for each product exceeds capacity, management would prefer to specialise according to your answer to part (e). At which plant should management produce the third product?