Question

Perez Bike Company makes the frames used to build its bicycles. During year 2, Perez made 24,000 frames; the costs incurred follow. Unit-level materials costs (24,000 units x $55) Unit-level labor costs (24,000 units x $58) Unit-level overhead costs (24,000 x $10) Depreciation on manufacturing equipment Bike frame production supervisor's salary Inventory holding costs Allocated portion of facility-level costs Total costs $1,320,000 1,392,000 240,000 94,000 81,400 310,000 470,000 $3,907,400 Perez has an opportunity to purchase frames for $118 each. Additional Information 1. The manufacturing equipment, which originally cost $570,000, has a book value of $460,000, a remaining useful life of 5 years, and a zero salvage value. If the equipment is not used to produce bicycle frames, it can be leased for $69,000 per year. 2. Perez has the opportunity to purchase for $920,000 new manufacturing equipment that will have an expected useful life of 5 years and a salvage value of $71,000. This equipment will increase productivity substantially, reducing unit-level labor costs by 60 percent. Assume that Perez will continue to produce and sell 24,000 frames per year in the future. 3. If Perez outsources the frames, the company can eliminate 80 percent of the inventory holding costs.

Answer 1

(A)

A Avoidable Manufacturing Cost for Bicycle Frames Unit Level Material Cost (24000*$55) Unit Level Labour Costs (24000*$58) Unit Level Overhead Cost (24000*$10) Opportunity cost of Equipment lease Bike frame Production Supervisor's Salary Inventory holding cost (310000*80%) Total Avoidable Cost (A) Total Units (B) Avoidable Cost per Unit Amount $ 1320000 1392000 240000 69000 81400 248000 3350400 24000 139.6 Based on the above calculation it can be seen that the avoidable cost per unit of $139.6 is greater than $118 per unit cost to purchase the frames. Therefore Perez should outsource the frames as it would increase the profits of 518400 (24000* (139.6- 118)]

(B) & (C)

B С Avoidable manufacturing cost with existing Equipment Amount $ Unit Level Labour Cost (24000*$58) 1392000 Avoidable Manufacturing cost for Bicycle Frames (New Equipment) Amounts Unit Level Material Cost (24000 $55) 1320000 Unit Level Labor Cost [24000*$58*(1- 60%)] 556800 Unit Level Overhead cost (24000*$10) 240000 Depreciation Exps on New Equipment ($920000-71000)/5 169800 Opportunity cost of Equipment lease Total Avoidable cost-C 69000 1461000 24000 Total Units (D) Avoidable cost per unit with existing Equipment 60.875 Bike frame Production Supervisor's Sa Inventory holding cost Total Avoidable cost (G) Total Units (H) 81400 248000 2616000 24000 Avoidable manufacturing cost with New Equipment Unit Level Labor Cost (24000"$58*(1- 60%)] 556800 Avoidable cost per unit (/H) 109 Depreciation cost of new equipment ($920000-71000)/5years ) Total Avoidable cost (E) Total Units (F) Avoidable cost per unit with New Equipment 169800 726600 24000 Perez would save $9 frame ($118-$109) if it replaces the old equipment rather than outsourcing the bike frames resulting in an increase in overall profit by $216000 (24000*$9). Therefore the old equipment should be replaced 30.275 It can be clearly seen that total avoidable cost of using existing equipment is higher by $734400 ($1461000-$726600) as compared to new equipment. Therefore profitability of Perez would increase if existing equipment is replaced with new one