Question

Perez Bike Company makes the frames used to build its bicycles. During 2018, Perez made 24,000 frames; the costs incurred follow:

Unit-level materials costs (24,000 units × $55)	$	1,320,000
Unit-level labor costs (24,000 units × $58)		1,392,000
Unit-level overhead costs (24,000 × $10)		240,000
Depreciation on manufacturing equipment		94,000
Bike frame production supervisor’s salary		81,400
Inventory holding costs		310,000
Allocated portion of facility-level costs		470,000
Total costs	$	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 five 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 five 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.

Required

1. Determine the avoidable cost per unit of making the bike frames, assuming that Perez is considering the alternatives of making the product using the existing equipment or outsourcing the product to the independent contractor. Based on the quantitative data, should Perez outsource the bike frames?

2. Assuming that Perez is considering whether to replace the old equipment with the new equipment, determine the avoidable cost per unit to produce the bike frames using the new equipment and the avoidable cost per unit to produce the bike frames using the old equipment. Calculate the increase or decrease in the company's profit if the company uses new equipment.

3. Assuming that Perez is considering whether to either purchase the new equipment or outsource the bike frame, calculate.

Answer 1

Answers :-

1.Avoidable Manufacturing Cost for Bicycle Frames

Particulars	Amount ($)
Unit Level Material Cost (24000 * $55)	1,320,000
Unit Level Labor Costs (24000 * $58)	1,392,000
Unit Level Overhead Cost (24000 * $10)	240,000
Opportunity cost of Equipment lease	69,000
Bike frame Production Supervisor;s salary	81,400
Inventory holding cost (310000 * 80%)	248,000
Total Avoidable Cost (A)	3,350,400
Total Units (B)	24,000
Avoidable Cost per Unit	139.6

By Above we can see that avoidable cost per unit $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 $18400 [24000*(139.6-118)].

2. Avoidable manufacturing cost with existing Equipment

Particulars	Amount($)
unit level labor cost (24000*$58)	1,392,000
Opportunity cost of Equipment lease	69,000
Total Avoidable Cost -C	1,461,000
Total Units (D)	24,000
Avoidable cost per unit with existing equipment	60.875
Avoidable manufacturing cost with new equipment
Unit level labor cost [24000*$ 58*(1-60%)	556,800
Depreciation cost of new equipment ($920000 - $71000)/ 5 years
Total Avoidable cost (E)	726,600
Total Units (F)	24,000
Avoidable cost per unit with New Equipment	30.275

On above total avoidable cost of using exiting 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.

3. Avoidable Manufacturing cost for Bicycle Frames (New Equipment)

Particulars	Amount($)
Unit Level Material Cost [24000*$55]	1,320,000
Unit Level Labor Cost [24000 * $58*(1-60%)]	556,800
Unit Level Overhead cost (24000* $ 10)	240000
Depreciation Expenses on New Equipment ($920000 - 71000) / 5	169800
Bike frame Production Supervisor's Sa	81400
Inventory holding cost	248000
Total Avoidable cost (G)	2616000
Total Units (H)	24000
Avoidable cost per unit (G/H)	109

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.