Question

Sturdy has an opportunity to purchase frames for $115 each.

Additional Information

1. The manufacturing equipment, which originally cost $570,000, has a book value of $420,000, 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 $73,000 per year.

2. Sturdy has the opportunity to purchase for $960,000 new manufacturing equipment that will have an expected useful life of five years and a salvage value of $77,500. This equipment will increase productivity substantially, reducing unit-level labor costs by 60 percent. Assume that Sturdy will continue to produce and sell 23,000 frames per year in the future.

3. If Sturdy outsources the frames, the company can eliminate 70 percent of the inventory holding costs.

Required

1. Determine the avoidable cost per unit of making the bike frames, assuming that Sturdy 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 Sturdy outsource the bike frames?

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

Answer 1

Requirement A	The avoidable cost per unit of making the bike frames would be calculated as follows:
	Material costs	$11,50,000
	Labor Costs	$13,34,000
	Overhead Costs	$2,07,000
	Bike frame production supervisors salary	$79,900
	Inventory holding cost	$2,62,500	($350,000*75%)
	Avoidable cost for making the product	$30,33,400
	Number of units	$23,000
	Avoidable cost per unit for making the product	$131.89
	As the avoidable cost per unit(i.e.$131.89) is more than the cost to outsource (i.e. $115), it is better to outsource the product.
	Total profit of the company would be$1,942,350 ($131.89-115)*115,000 units.
	Note: Depreciation would not be included as it is a non cash expense.
	Avoidable cost per unit for making the product	$131.89	Per unit
	Sturdy should outsource the bike frames?	Yes
Requirement B	Avoidable cost of using old machine during the life of machine
	Opportunity cost	365000	($73,000*5 years)
	Labor cost	6670000	($1,334,000*5 years)
	Total avoidable cost	7035000	($365,000+$6,670,000)
	Number of units	115000	(23,000*5 years)
	Avoidable cost per unit	$61.17	($7,035,000/115,000)
	Avoidable cost of using new machine during the life of machine
	Cost of new machine	960000
	Labor cost	2668000	($1,334,000*5 years*40%)	Since the new machine would decrease the labor cost by 60% the remaining labor cost would be 40%.
	Total avoidable cost	3628000	($960,000+2,668,000)
	Number of units	115000	(23,000*5 years)
	Avoidable cost per unit	$31.55	($3,628,000/115,000)
		Old machine	New machine
	Avoidable cost per unit	$61.17	$31.55
	Profit must increase by	$ 3,407,000.00	Per unit
		($61.17-31.55)*115,000
Requirement C	Sturdy should purchase the new equipment
	Profit must increase by	$ 1,464,650.00
		($3,407,000-$1,942,350)