Question

Exercise 12-3 Make or Buy Decision [LO12-3]

Troy Engines, Ltd., manufactures a variety of engines for use in heavy equipment. The company has always produced all of the necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of carburetor to Troy Engines, Ltd., for a cost of $34 per unit. To evaluate this offer, Troy Engines, Ltd., has gathered the following information relating to its own cost of producing the carburetor internally:

	Per Unit				19,000 Units Per Year
Direct materials	$	16		$	304,000
Direct labor		10			190,000
Variable manufacturing overhead		2			38,000
Fixed manufacturing overhead, traceable		9	*		171,000
Fixed manufacturing overhead, allocated		12			228,000
Total cost	$	49		$	931,000

*One-third supervisory salaries; two-thirds depreciation of special equipment (no resale value).

Required:

1. Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 19,000 carburetors from the outside supplier?

2. Should the outside supplier’s offer be accepted?

3. Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $190,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 19,000 carburetors from the outside supplier?

4. Given the new assumption in requirement 3, should the outside supplier’s offer be accepted?

Answer 1

Requirement 1

Financial (Disadvantage)

$      (57,000.00)

Working

Statement of Cost Analysis(19000 Units)
					Make	Buy	Inremental (cost) or benefit
Purchase Price	$                        -	$      646,000.00	$      (646,000.00)
Direct Material	$      304,000.00	$                        -	$        304,000.00
Direct labor	$      190,000.00	$                        -	$        190,000.00
Variable Manufacturing Overheads	$        38,000.00	$                        -	$          38,000.00
Fixed Manufacturing Overheads,Avoidable	$        57,000.00		$          57,000.00
Opportunity cost			$                          -
Total Relevant Cost	$      589,000.00	$      646,000.00	$        (57,000.00)

.

Requirement 2

No

The offer should be rejected

Requirement 3

Financial Advantage

$      133,000.00

Working

Statement of Cost Analysis(19000 Units)
					Make	Buy	Inremental (cost) or benefit
Purchase Price	$                        -	$      646,000.00	$      (646,000.00)
Direct Material	$      304,000.00	$                        -	$        304,000.00
Direct labor	$      190,000.00	$                        -	$        190,000.00
Variable Manufacturing Overheads	$        38,000.00	$                        -	$          38,000.00
Fixed Manufacturing Overheads,Avoidable	$        57,000.00		$          57,000.00
Opportunity cost	$      190,000.00		$        190,000.00
Total Relevant Cost	$      779,000.00	$      646,000.00	$        133,000.00

.

Requirement 4

Yes

The offer should be accepted.

.

Supervisor salary is avoidable fixed cost. It will be saved if carburator is purchased from outside but depreciation will still be the same , so 2/3rd of fixed cost still occurs when Carburator is purchased. Which means Depreciation is Irrelevant cost and hence excluded from relevant cost calculation.