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 $40 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	$	15		$	225,000
Direct labor		11			165,000
Variable manufacturing overhead		2			30,000
Fixed manufacturing overhead, traceable		9	*		135,000
Fixed manufacturing overhead, allocated		12			180,000
Total cost	$	49		$	735,000

*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 the 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. Assuming the company has no alternative use for the facilities
Cost of buying carburetor ($40 * 15,000) = $600,000

Savings in manufacturing cost:
Direct material ($15 * 15,000) = $225,000
Direct labor ($11 * 15,000) = $165,000
Var. manufacturing overhead ($2 * 15,000) = $30,000
Fixed manufacturing overhead ($135,000 * 1/3) = $45,000
Total savings in cost = $465,000

Financial advantage (disadvantage) of buying 15,000 carburetors from the outside supplier :
= Savings in manufacturing cost - Cost of buying
= $465,000 - $600,000
= $(135,000) i.e. disadvantage

2). The outside supplier offer should not be accepted as it will result in financial disadvantage of $135,000.

3). Suppose that if the carburetors were purchased it could use the freed capacity for the segment margin of $150,000 per year.
Financial advantage (disadvantage) of buying 15,000 carburetors from the outside supplier = $(135,000)
Add: Segment margin = $150,000
Net financial advantage (disadvantage) = $15,000 i.e advantage

4). Given the new assumption in requirement 3, the outside supplier’s offer should be accepted as it would result in financial advantage of $15,000 per year.