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 $30 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	$	12		$	228,000
Direct labor		10			190,000
Variable manufacturing overhead		3			57,000
Fixed manufacturing overhead, traceable		3	*		57,000
Fixed manufacturing overhead, allocated		6			114,000
Total cost	$	34		$	646,000

*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 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

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

To calculate the financial advantage or disadvantage, we will calculate the relevant cost for both making and buying and see the difference.

Relevant costs are the incremental and avoidable costs which help in decision making.

particulars	make $	particulars	buy $
direct material	12		0
direct labour	10		0
variable manufacturing overhead	3		0
fixed overhead traceable	1*		0
total cost	26		30(given)
for 19000 units	494000		570000
difference between the cost of making and buying	494000-570000 = -76000 26-30 = -4
we see that there is a negative difference i.e., cost of buying is greater than the cost of making
FINANCIAL DISADVANTAGE OF BUYING 19000 UNITS INSTEAD OF MAKING IS $76000.

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

ONLY SUPERVISORY SALARIES ARE TAKEN AS THEY ARE RELEVANT FOR DECISION MAKING

DEPRECIATION OF SPECIAL EQIUPMENT IS IRRELEVANT TO DECISION MAKING AS IT IS A SUNK CASO(PAST COST) .

NOTE:

Fixed manufacturing overhead, allocated are irrelevant to decision making and are not taken into consideration for calculating the total relevant costs. 2. Should the outside supplier’s offer be accepted? NO. as the relevant cost of buying is greater than the cost of making, causing a financial disadvantage. 3. Suppose that if the carburettors 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 carburettors from the outside supplier?

cost of buying = 570000$ or 30$ per unit

cost of making = 494000 + oppurtunity cost forgone on a pottential new launch.

= 494000 + 190000

= 684000 or 36$ per unit

opportunity cost is the benefit missed when you choose one over the other alternative i.,

the loss of other alternatives over the chose alternative.

Hence we add it to our total relevant cost of making the carburettors.

Thus the cost of making is greater than the cost of buying, indicating a clear financial advantage of buying the carburettor

684000-570000 = 114000 $ for 19000 units.

36 - 30 = 6$ per unit .

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

YES as there is a financial advantage of 114000$ on buying the carburettors instead of making it.

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