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	$	183,000	$	97,600	$	280,600
Less variable expenses		97,600		56,120		153,720
Contribution margin	$	85,400	$	41,480	$	126,880
Less direct fixed expenses*		24,400		46,360		70,760
Segment margin	$	61,000	$	(4,880)	$	56,120
Less common fixed expenses						36,600
Operating income					$	19,520
* Includes depreciation.

The density gauge uses a subassembly that is purchased from an external supplier for $25 per unit. Each quarter, 2,440 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 $32,940 per quarter for the space and $12,200 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 $46,360, $9,760 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 3,416 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

1)Solution : The best option is to Drop Thickness guage and make the assembly as the relevant cost of this option is the lowest

	Lease and Make	Buy	Drop Thickness guage and make
Total Relevant Costs ($ )	$ 62,220(Note1(b))	$ 61,000( note1(c ))	$ 53,680(Note1 {(d)(1) and (d)(2)}

Note1:

a. Cost of making the sub-assembly= $2+$3+$2= $7 per sub-assembly

b. Lease and Make option:

Leasing Space and Equipment $ 32,940

Supervisory Charges$ 12,200

Cost of making the sub-assembly$ 17,080{note(1)(a)}

Total RelevantCost under leasing option $ 62,220

c. Cost of Buying the 2440 sub-assemblies are as follows

=2440* $25 per unit=$ 61000

d. (1) Dropping Thickness guage and making the sub-assembly

Relevant costs:

Cost of making the sub-assembly($7*2440) =$ 17,080

Relevant direct fixed costs=$ 36,600

Total Relevant cost of dropping thickness guage option= $ 53,680

(2)Depreciation expense of $9760 is not taken into consideration as it is a sunk cost and it has been incurred in the past and has no relevance to any of the alternative options considered i.e whether sub-assembly is Manufactured or thickness guage is manufactured.

2) Solution : The best option is Keep the thickness guage and Buy the sub assemblies i.e If the dropping of Thickness guage and making the sub-assembly leads to a drop in the demand of Density guage by 10% then the option or alternative with the lowest cost is keeping the Thickness guage and Buying option at $ 61000

	Lease and Make	Buy	Drop Thickness guage and make
Total Relevant Costs ($ )	$ 62,220(Note1(a))	$ 61,000( note1(b ))	$ 62,220(Note1{(c )(1) and(c )(2)}

Note1:

a. Lease and Make option:

Leasing Space and Equipment $ 32,940

Supervisory Charges $ 12,200

Cost of making the sub-assembly $ 17,080

Total RelevantCost under leasing option $ 62,220

b. Cost of Buying the 2440 sub-assemblies are as follows

=2440* $25 per unit=$ 61000

c. (1)Dropping Thickness guage and making the sub-assembly

Relevant costs:

Cost of making the sub-assembly($7*2440) = $ 17,080

Relevant direct fixed costs= $ 36,600

Loss of Contribution from Density guage due to

Dropping of sales of Density Guage(0.10*$ 85400}=$8,540

Total Relevant cost of dropping thickness guage option= $ 62,220

(2)Depreciation expense of $9760 is not taken into consideration as it is a sunk cost and it has been incurred in the past and has no relevance to any of the alternative options considered i.e whether sub-assembly is Manufactured or thickness guage is manufactured

3) Solution: The company is indifferent between the 2 options of leasing& making option and Dropping Thickness guage and making option as both give the same cost as $ 69052

	Lease and Make	Buy	Drop Thickness guage and make
Total Relevant Costs ($ )	$ 69,052 (Note1(b))	$ 85,400 ( note1(c ))	$ 69,052(Note1{(d )(1) &(d )(2)}

Note1:

a. Cost of making the sub-assembly         $ 23,912

(3416 *$7 per sub-assembly)

b. Lease and Make option:

Leasing Space and Equipment $ 32,940

Supervisory Charges $ 12,200

Cost of making the sub-assembly $ 23,912

Total RelevantCost under leasing option $ 69,052

c. Cost of Buying the 3416 sub-assemblies are as follows

=3416* $25 per unit=$ 85,400

d. (1)Dropping Thickness guage and making the sub-assembly

Relevant costs:

Cost of making the sub-assembly($7*3416) = $ 23,912

Relevant direct fixed costs= $ 36,600

Loss of Contribution from Density guage due to

Dropping of sales of Density Guage(0.10*$ 85400}= $8,540

Total Relevant cost of dropping thickness guage option= $ 69,052

(2)Depreciation expense of $9760 is not taken into consideration as it is a sunk cost and it has been incurred in the past and has no relevance to any of the alternative options considered i.e whether sub-assembly is Manufactured or thickness guage is manufactured