Question

“That old equipment for producing carburetors is worn out,” said Bill Seebach, president of Hondrich Company. “We need to make a decision quickly.” The company is trying to decide whether it should rent new equipment and continue to make its carburetors internally or whether it should discontinue production of its carburetors and purchase them from an outside supplier. The alternatives follow:

     Alternative 1: Rent new equipment for producing the carburetors for $140,000 per year.
     Alternative 2: Purchase carburetors from an outside supplier for $19.35 each.

     Hondrich Company’s costs per unit of producing the carburetors internally (with the old equipment) are given below. These costs are based on a current activity level of 35,000 units per year:

Direct materials	$	5.40
Direct labour		10.00
Variable overhead		1.60
Fixed overhead ($2.00 supervision, $1.80 depreciation,     and $4.00 general company overhead)		7.80
Total cost per unit	$	24.80

     The new equipment would be more efficient and, according to the manufacturer, would reduce direct labour costs and variable overhead costs by 25%. Supervision cost ($70,000 per year) and direct materials cost per unit would not be affected by the new equipment. The new equipment’s capacity would be 50,000 carburetors per year.

     The total general company overhead would be unaffected by this decision.

Required:
1. Seebach is unsure what the company should do and would like an analysis showing the unit costs and total costs for each of the two alternatives given above. Assume that 35,000 carburetors are needed each year.

a. What will be the total relevant cost of 35,000 subassemblies if they are manufactured internally as compared to being purchased?

b. What would be the per unit cost of the each subassembly manufactured internally? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. Which course of action would you recommend to the president?

• Manufacture internally

• Indifferent between the two alternatives

• Purchase from the outside supplier

2. Seebach is unsure what the company should do and would like an analysis showing the unit costs and total costs for each of the two alternatives given above.

a-1. What will be the total relevant cost of 40,000 subassemblies if they are manufactured internally?

a-2. What would be the per unit cost of subassembly? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

a-3. Which course of action would you recommend if 40,000 assemblies are needed each year?

• Indifferent between the two alternatives

• Purchase from the outside supplier

• Manufacture internally

b-1. What will be the total relevant cost of 50,000 subassemblies if they are manufactured internally?

b-2. What would be the per unit cost of subassembly? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b-3. Which course of action would you recommend if 50,000 assemblies are needed each year?

• Indifferent between the two alternatives

• Purchase from the outside supplier

• Manufacture internally

Answer 1

As the General Company Overheads are not changed with the change in the Decision, It is Irrelevant cost.

Irrelevant cost is the cost which does not change with the change in the decision or it is already incurred

1. a) Total relevent cost if the subassemblies are manufactured

Rent of New Machinery 140,000

Direct Materials   189,000 ( 5.4 * 35000 )

Direct Labour    262,500 ( 7.5*35000 ) [10.00-25%(Reduction in cost due to new machinary)= 7.5]

Variable Overheads 42,000 (1.2*35000)

Fixed Overheads 70,000 (Fixed cost excluding General Company Overeads and Depreciation as it is not relevant and assuming the rent is not part of the general Company Overheads)

Total Relevant Cost $ 703,500 Per annum

b)  Total relevant cost per unit is the subasseblies are manufactured internally

Total relevant cost per annum/ No of units to be produced = 703,500/35000

= 20.10 per unit

c)  Since the manufacturing cost per unit (20.10) is greater than the cost of purchase cost per unit (19.35), It is better to purchase the subassemblies from outside

Indifference Point

Indifference point = change in Fixed cost/ change in variable cost

[supervision cost(70,000) + Rent of Machinery(140000)] / Variable cost (19.35-14.10)

= 210,000/5.25

Level of Indifference =40,000 units

Total Relevant Cost

Particulars 40000 units 50000 units

Rent of Machinery 140,000 140,000

Direct Material (5.4 per unit) 216,000    270,000

Direct Labour (7.5 per unit ) 300,000 375,000

Variable Overhead (1.2 per unit) 48,000 60,000

A) Total Variable cost ( 14.1 per unit)    564,000     705,000

Fixed Cost ( Supervision cost)    70,000    70,000

B) Total Fixed Cost (Rent + Supervision cost) 210,000 210,000

Total Relevant Cost [ A+ B ] 774,000 915,000

Total Relevant Cost per unit 19.35 18.3

Therefore, The Indifference point is 40000 units.

Hence If the company has the requirement of more than 40000 units, it is better to rent the machinery and make the production.

If the requirement is Less than 40000 units, then it is better to purchase the subassemblies from outside at $19.35 per unit.

If the requirement is equal to 40000 units, the decision is Indefferent.

The Above Decision should be taken appropriatly considering the reliability, credibility and Price consistency from the supplier from whom the purchase to be made.