Question

Sturdy Bike Company makes the frames used to build its bicycles. During year 2, Sturdy made 20,000 frames; the costs incurred follow.

Unit-level materials costs (20,000 units × $35.00)	$	700,000
Unit-level labor costs (20,000 units × $42.50)		850,000
Unit-level overhead costs (20,000 × $10.00)		200,000
Depreciation on manufacturing equipment		120,000
Bike frame production supervisor’s salary		70,000
Inventory holding costs		290,000
Allocated portion of facility-level costs		500,000
Total costs	$	2,730,000

Sturdy has an opportunity to purchase frames for $92.50 each.

Additional Information

1. The manufacturing equipment, which originally cost $550,000, has a book value of $450,000, a remaining useful life of four years, and a zero salvage value. If the equipment is not used to produce bicycle frames, it can be leased for $70,000 per year.
2. Sturdy has the opportunity to purchase for $910,000 new manufacturing equipment that will have an expected useful life of four years and a salvage value of $70,000. This equipment will increase productivity substantially, reducing unit-level labor costs by 60 percent. Assume that Sturdy will continue to produce and sell 20,000 frames per year in the future.
3. If Sturdy 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 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 or outsource, calculate the impact on profitability between the two alternatives.

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? (Round your answer to 2 decimal places.)

	Avoidable cost per unit for making the product $106.10 per unit Should Sturdy outsource the bike frames? Yes

ssuming 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. (Round "Avoidable cost per unit" to 2 decimal places.)

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	Old Equipment New Equipment Avoidable cost per unit $46.00 $27.50 Profit must increase by

Assuming that Sturdy is considering whether to either purchase or outsource, calculate the impact on profitability between the two alternatives. (Do not round intermediate calculations.)

	Should Sturdy purchase new equipment or outsource? Purchase Profit must increase by

Answer 1

Requirement-(a)

To determine the rightful decision about outsourcing we first must find out the avoidable cost to use the old equipment.

Avoidable Costs:
Materials	700,000
Labor	850,000
Overhead	200,000
Production Salary	70,000
Holding on inventory cost (290,000*80%)	232,000
Opportunity Cost	70,000
	2,122,000

Total avoidable costs = $2,122,000 / 20,000 units = $106.10 per unit cost to make.

We don't include depreciation because it does not have a cash flow value. Since, it costs $92.50 to outsource less than $106.10 per unit to make, he should outsource because he would be saving ($ 106.10-92.50)*20,000 = $272,000.

Requirement (b1):

Avoidable Costs using old machine (4 years)
Opportunity cost (70,000*4)	280,000
Unit labor cost (850,000*4)	3,400,000
	3,680,000

Avoidable cost = $ 3,680,000 / 80,000 = $46 avoidable cost per unit

Units to be produced in 4 years (20,000*4) = 80,000

(b2):

Cost of owning new machine = 910,000

Salvage value = 70,000

Unit labor costs $1,360,000 ''reducing unit level cost by 60%'' [(3,400,000*0.60)-3,400,000]

Total avoidable cost = $ 2,200,000/80,000 = $27.50 per unit cost to make.

Based on these calculations the total avoidable cost of using the old machine is higher by $1,480,000 [3,680,000-2,200,000] when compared to the new equipment. Hence, the profitability of the company would increase by $1,480,000 if the old equipment is replaced by the new equipment.

Requirement (c):

When considering whether purchase new equipment or outsourcing we need to find the avoidable cost for bicycle frames (new equipment).

(the deal was to outsource at $92.50)

Avoidable Costs:
Materials	700,000
Labor	340,000
Overhead	200,000
Depreciation (910,000-70,000/4)	210,000
Salary	70,000
Inventory Holding (290,000*80%)	232,000
Opportunity Cost	70,000
	1,752,000

Total avoidable = $1,752,000/20,000 = $87.60 per unit

We don't include depreciation, salary and inventory holding because it has already been incurred to make the product. The company would save ($92.50-87.60) = $4.90 if he replaces the old equipment rather than outsourcing. That would increase profitability by $98,000 (20,000 units*$4.90)

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