Question

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 $35 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				15,000 Units Per Year
Direct materials	$	14		$	210,000
Direct labor		10			150,000
Variable manufacturing overhead		3			45,000
Fixed manufacturing overhead, traceable		6	*		90,000
Fixed manufacturing overhead, allocated		9			135,000
Total cost	$	42		$	630,000

*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 15,000 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 $150,000 per year. Given this new assumption, what would be financial advantage (disadvantage) of buying 15,000 carburetors from the outside supplier?

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

Answer 1

1.

Cost of buying carburetors from outside supplier
Purchase Price	$ 5,25,000.00
Depreciation	$     60,000.00
Fixed Manufacturing Overhead, allocated	$ 1,35,000.00
Total Cost	$ 7,20,000.00

Purchase Price is 15000 x $35 = $525000
Depreciation will still be incurred = $60000
Supervisor salary can be eliminated, since his services will not be needed
Fixed manufacturing overhead, allocated will still be there as there is no alternate use.

Since Purchase cost is higher than manufacturing cost, it is financial disadvantage to buy from outside supplier
Financial Disadvantage = $720000 - $630000 = $90000

2. Since it is financial disadvantage to buy from outside supplier, offer should not be accepted.

3.

Cost of buying carburetors from outside supplier
Purchase Price	$ 5,25,000.00
Depreciation	$     60,000.00
Supervisor Salary	$     30,000.00
Fixed Manufacturing Overhead, allocated	$ 1,35,000.00
New segment Contribution	$-1,50,000.00
Total Cost	$ 6,00,000.00

Since utilising idle capacity will generate contribution of $150000 which will reduce net cost of purchasing.
and since new line is added, supervisor will be needed which increases the cost.

Net Purchasing cost is less than Manufacturing cost, there is financial advantage
Financial Advantage = $630000 - $600000 = $30000

4. Since it is financial advantage to buy from outside supplier, offer should be accepted.