Question

Relevance, short-term. (A. Atkinson) Oxford Engineering manufactures small engines. The engines are sold to manufacturers who install them in such products as lawn mowers. The company current y manufactures all the parts used in these engines but is considering a proposal from an external supp mr who wants to supply the starter assembly used in these engines. The starter assembly is currently manu factured in Division 3 of Oxford Engineering. The costs relating to Division 3 for the past 12 months were as follows: Direct materials Direct manufacturing labour Manufacturing overhead Total $220,000 165,000 440,000 $825,000 Over the past year, Division 3 manufactured 150,000 starter assemblies; the average cost for the starter assembly is computed as $5.50 (= $825,000 = 150,000). Further analysis of manufacturing overhead revealed the following information. Of the total manu ac turing overhead reported, only 25% is considered variable. Of the fixed portion, $150,000 is an allocation O general overhead that would remain unchanged for the company as a whole if production of the starter assembly is discontinued. A further $100,000 of the fixed overhead is avoidable if self-manufacture of the starter assembly is discontinued. The balance of the current fixed overhead, $80,000, is the division man ager's salary. If self-manufacture of the starter assembly is discontinued, the manager of Division 3 wil be transferred to Division 2 at the same salary. This move will allow the company to save the $40,000 salary that would otherwise be paid to attract an outsider to this position. Required 1. Tidnish Electronics, a reliable supplier, has offered to supply starter assembly units at $4 per unit. Since this price is less than the current average cost of $5.50 per unit, the vice-president of manufacturing is eagerto accept this offer. Should the outside offer be accepted? (Hint: Production output in the coming year may be different from production output in the last year.) 2. How, if at all, would your response to requirement 1 change if the company could use the vacated plant space for storage and, in so doing, avoid $50,000 of outside storage charges currently incurred? Why is this information relevant or irrelevant?

Answer 1

Requirement-1:

Calculation of variable cost per unit:
Direct material	$ 2,20,000
Direc labor	1,65,000
Variable manufacturing overhead ($440,000 × 25%)	1,10,000
Total variable costs	$ 4,95,000

Variable cost per unit ($495,000 / 150,000)

Note that production output in the coming year may be different from production output in the past year.

Let X be the number of start er assemblies required in the next 12 months

Relevant cost:
	Make	Buy
Variable manufacturing cost	$3.30X	-
Avoidable fixed overhead	1,00,000	-
Division-2 manager's salary	40,000	80,000
Division-3 manager's salary	80,000
Purchase cost		$4X
Total relevant cost	$220,000 + $3.30X	$80,000 + $4X

Indirrerence Point = ($220,000 - 80,000) / ($4.00 - 3.30) = 200,000 units

The number of units at which the costs of insourcing and outsourcing are equivalent is, X = 200,000 units

Comment:

(i) If production is expected to be less than 200,000 units, it is preferable to buy units from Tidnish.

(ii) If production is expected to exceed 200,000 units, it is preferable to manufacture internally (make) the units.

(iii) If production is expected to be 200,000 units, Oxford should be indifferent between buying units from Tidnish and manufacturing (making) the units internally.

Requirement-2:

The information on the avoidable storage cost of $50,000 is relevant. It is an opportunity cost if insourcing is chosen.

Conclusion:

The justification provided by the V.P. of manufacturing is wrong because she implicitly considered all fixed costs avoidable.

The justification provided by the G.M. is wrong because she implicitly considered all fixed costs unavoidable.