BFR is a ship-building firm that has just won a government contract to build 10 high-spe...

BFR is a ship-building firm that has just won a government contract to build 10 high-speed patrol boats for the Coast Guard for drug interdiction and surveillance. Besides building ships for the government, BFR has a commercial vessel division that designs and manufactures commercial fishing and commuting ships. The commercial division and the government division are the only two divisions of BFR, and the Coast Guard contract is the only work in the government division.

The Coast Guard contract is a cost-plus contract. BFR will be paid its costs plus 5 percent of total costs to cover profits. Total costs include all direct materials, direct labor, purchased subassemblies (engines, radars, radios, etc.), and overhead. Overhead is allocated to the Coast Guard contract based on the ratio of direct labor expense on the contract to firmwide direct labor.

BFR can either purchase the engines from an outside source or build them internally. The following table describes the costs of the commercial division and the Coast Guard contract if the engines are built by BFR versus purchased outside.

BFR Cost Structure ($ in Millions)

Overhead for BFR is $83.5 million and does not vary if the engines are purchased outside or manufactured inside BFR. Overhead consists of corporate-level salaries, building depreciation, property taxes, insurance, and factory administration costs.

Required:

a. How much overhead is allocated to the Coast Guard contract if

(i) The engines are manufactured internally?

(ii) The engines are purchased outside?

b. Based on the total contract payment to BFR, will the Coast Guard prefer BFR to manufacture or purchase the engines?

c. What is the difference in net cash flows to BFR of manufacturing versus purchasing the engines?

d. Explain how cost-plus reimbursement contracts in the defense industry affect the make-buy decision for subassemblies.