Question

"That old equipment for producing carburetors is worn out," said Bill Seebach, president of Hondrich Company. "We need to make a decision quickly." The company is trying to decide whether it should rent new equipment and continue to make its carburetors internally or whether it should discontinue production of its carburetors and purchase them from an outside supplier. The alternatives follow: Alternative 1: Rent new equipment for producing the carburetors for $115,000 per year. Alternative 2: Purchase carburetors from an outside supplier for $16.95 each. Hondrich Company's costs per unit of producing the carburetors internally (with the old equipment) are given below. These costs are based on a current activity level of 25,000 units per year: Direct materials Direct labour Variable overhead Fixed overhead ($2.30 supervision, $1.80 depreciation, and $4.00 general company overhead) $ 5.10 8.00 2.80 8.10 Total cost per unit $24.00 The new equipment would be more efficient and, according to the manufacturer, would reduce direct labour costs and variable overhead costs by 25%. Supervision cost ($57,500 per year) and direct materials cost per unit would not be affected by the new equipment. The new equipment's capacity would be 50,000 carburetors per year.

Answer 1

$502,500 $20.10 See Note (ii) Ans 1 a Total relevant cost of 25000 subassemplies Ans 1 b Per unit cost of subassemplies Ans 1 c Purchase form outside Ans 2 a 1 Total relevant cost of 46000 subassemplies Ans 2 a 2 Per unit cost of subassemplies Ans 2 a 3 Indifferent between the two alternatives Ans 2 b 1 Total relevant cost of 50000 subassemplies Ans 2 b 2 Per unit cost of subassemplies Ans 2 b3 Manufacture internally 779,700 $16.95 See Note (iii) $832,500 $16.65 See Note (iv) Working Note (i) Total Cost of 30000 subassemplied manufactured internally After taking the new machinery the cost will be as under: Particulars Old Cost/unit percentage New Cost/unit Direct Material Direct Labor Variable Overhead (A) (B) $5. 100 $8.00 $2.80 [(A) x (1-(B)] $5.10 $6.00 $2.10 25% 25%

Cost / Unit Amount Amount Note (ii) Cost of 25000 Subassemblies Particulars Direct Cost Direct Material Direct Labor Variable Overhead $5.10 $6.00 $2.10 $127,500 $150,000 $ 52,500 $330,000 Add: Fixed Overhead Rent for New Equipment Supervision (25000 x $2.3] Total Cost $115,000 $57,500 $172,500 $502,500 Subassemplies Produced 25,000 Cost/Subassemblies [$502500 / 25000] $20.10 Manufacturing cost/ subassemplies $20.10 Purchase Cost/subassemblies $16.95 Since there is a saving of $ 3.15/subassemplies on purchase from Outside Supplier, the Company should go for Purchase from Outside Supplier

Cost / Unit Amount Amount Note (iii) Cost of 46000 subassemblies Particulars Direct Cost Direct Material Direct Labor Variable Overhead $5.10 $6.00 $2.10 234,600 276,000 96,600 607,200 Add: Fixed Overhead Rent for New Equipment Supervision Total Cost 115,000 57,500 172,500 779,700 Subassemplies Produced 46,000 Cost/Subassemblies [$ 779700 / 46000] $16.95 Manufacturing cost/ subassemplies $16.95 Purchase Cost/subassemblies $16.95 Since the manufacturing cost and purchase cost is same, the company can either purchase from outside or can manufacture the subassemblies

Cost / Unit Amount Amount Note (iv) Cost of 50000 subassemblies Particulars Direct Cost Direct Material Direct Labor Variable Overhead $5.10 $6.00 $2.10 $255,000 $300,000 $105,000 $660,000 Add: Fixed Overhead Rent for New Equipment Supervision Total Cost $115,000 $57,500 $172,500 $832,500 Subassemplies Produced $50,000 Cost/Subassemblies ($832500 / 50000] $16.65 Manufacturing cost/ subassemplies $16.65 Purchase Cost/subassemblies $16.95 Since there is a saving of $ 0.30/subassemblies on manufacturing, the Company should manufacture the subassemblies. Note (v) a General administrative overhead does not have a bearing on this decision because this expense is going to be incurred whether subassemplies is manufactured or purchased from outside. b Depreciation is not considered as it is a sunk cost c Supervision cost is considered because this expenditure will not be required if the subassemplies are purchased from outside.