AB produces a consumable compound X, used in the preliminary stage of a technical process that it installs in customers' factories worldwide. An overseas competitor, CD, offering an alternative process which uses the same preliminary stage, has developed a new compound, Y, for that stage which is both cheaper in its ingredients and more effective than X.

 At present, CD is offering Y only in its own national market, but it is expected that it will not be long before it extends its sales overseas. Both X and Y are also sold separately to users of the technical process as a replacement for the original compound that eventually loses its strength. This replacement demand amounts to 60% of total demand for X and would do so for Y. CD is selling Y at the same price as X ($64.08 per kg). 

AB discovers that it would take 20 weeks to set up a production facility to manufacture Y at an incremental capital cost of $3,500 and the comparative manufacturing costs of X and Y would be:  

                                                                                                                    X                          Y  

                                                                                                             $ per kg              $ per kg 

Direct materials                                                                                   17.33                     4.01 

Direct labour                                                                                           7.36                      2.85  

                                                                                                                 24.69                     6.86 

AB normally absorbs departmental overhead at 200% of direct labour: 30% of this departmental overhead is variable directly with direct labour cost. Selling and administration overhead is absorbed at one half of departmental overhead. 

The current sales of X average 74 kg per week and this level (whether of X or of Y if it were produced) is not expected to change over the next year. Because the direct materials for X are highly specialised, AB has always had to keep large inventories in order to obtain supplies. At present, these amount to $44,800 at cost. Its inventory of finished X is $51,900 at full cost. Unfortunately, neither X nor its raw materials have any resale value whatsoever: in fact, it would cost $0.30 per kg to dispose of them. 

Over the next three months AB is not normally busy and, in order to avoid laying off staff, has an arrangement with the trade union whereby it pays its factory operators at 65% of their normal rate of pay for the period while they do non-production work. AB assesses that it could process all its relevant direct materials into X in that period, if necessary. 

There are two main options open to AB. 

(i) To continue to sell X until all its inventories of X (both of direct materials and of finished inventory) are exhausted, and then start sales of Y immediately afterwards. 

(ii) To start sales of Y as soon as possible and then to dispose of any remaining inventories of X and/or its raw materials.