Question

Make-or-Buy, Traditional Analysis

Morrill Company produces two different types of gauges: a density gauge and a thickness gauge. The segmented income statement for a typical quarter follows.

	Density Gauge		Thickness Gauge		Total
Sales	$	150,000	$	80,000	$	230,000
Less variable expenses		80,000		46,000		126,000
Contribution margin	$	70,000	$	34,000	$	104,000
Less direct fixed expenses*		20,000		38,000		58,000
Segment margin	$	50,000	$	(4,000)	$	46,000
Less common fixed expenses						30,000
Operating income					$	16,000
* Includes depreciation.

The density gauge uses a subassembly that is purchased from an external supplier for $25 per unit. Each quarter, 2,000 subassemblies are purchased. All units produced are sold, and there are no ending inventories of subassemblies. Morrill is considering making the subassembly rather than buying it. Unit-level variable manufacturing costs are as follows:

Direct materials	$2
Direct labor	3
Variable overhead	2

No significant non-unit-level costs are incurred.

Morrill is considering two alternatives to supply the productive capacity for the subassembly.

Lease the needed space and equipment at a cost of $27,000 per quarter for the space and $10,000 per quarter for a supervisor. There are no other fixed expenses.

Drop the thickness gauge. The equipment could be adapted with virtually no cost and the existing space utilized to produce the subassembly. The direct fixed expenses, including supervision, would be $38,000, $8,000 of which is depreciation on equipment. If the thickness gauge is dropped, sales of the density gauge will not be affected.

Required:

1. Should Morrill Company make or buy the subassembly?
Make the subassembly

If it makes the subassembly, which alternative should be chosen?
Drop the thickness gauge

Enter the relevant costs of each alternative.

	Lease and Make	Buy	Drop Thickness Gauge and Make
Total relevant costs	$______________	$_____	$___________________________

2. Suppose that dropping the thickness gauge will decrease sales of the density gauge by 10 percent. What decision should now be made?

Keep the thickness gauge and buy the subassembly

3. Assume that dropping the thickness gauge decreases sales of the density gauge by 10 percent and that 2,800 subassemblies are required per quarter. As before, assume that there are no ending inventories of subassemblies and that all units produced are sold. Assume also that the per-unit sales price and variable costs are the same as in Requirement 1. Include the leasing alternative in your consideration. Now, what is the correct decision?

Lease the space and make the subassembly

Answer 1