Question

Waterways has discovered that a small fitting it now manufactures at a cost of $1.00 per unit could be bought elsewhere for $0.81 per unit. Waterways has fixed costs of $0.20 per unit that cannot be eliminated by buying this unit. Waterways needs 446,000 of these units each year.

If Waterways decides to buy rather than produce the small fitting, it can devote the machinery and labor to making a timing unit it now buys from another company. Waterways uses approximately 400 of these units each year. The cost of the unit is $13.28. To aid in the production of this unit, Waterways would need to purchase a new machine at a cost of $2,356, and the cost of producing the units would be $10.30 a unit.

Without considering the possibility of making the timing unit, evaluate whether Waterways should buy or continue to make the small fitting.

What is Waterways’ opportunity cost if it chooses to buy the small fitting and start manufacturing the timing unit?

Would it be wise for Waterways to buy the fitting and manufacture the timing unit?

Answer 1

1. Without considering the possibility of making the timing unit, evaluate whether Waterways should buy or continue to make the small fitting.

If company choose buy over manufacturing of small fitting it has to pay extra $4460 which it could save by manufactuing the same. So it should continue to manufacture small fitting and leading to savins of $4460.

Total opportunity cost due to purchasing small Fitting

(446000*0.01)

$              4,460.00

Waterways should continue making small fitting .

2. What is Waterways’ opportunity cost if it chooses to buy the small fitting and start manufacturing the timing unit?

Total opportunity cost due to purchasing small Fitting

(446000*0.01)

$              4,460.00

when company choose to buy fitting equipment it will pay 0.81 per unit i.e. 0.01 (0.81 - 0.80) over its manufacturing cost of 0.80 (1.00-0.20). Fixed cost of .20 is irrelevant .

3. Would it be wise for Waterways to buy the fitting and manufacture the timing unit?

Savings due to manufacturing timing unit
Production cost	(500*10.30)	$              4,120.00
Add: Cost of machine		$              2,356.00
(capacity or life of machine is not given so added in full here)
Total manufacturing cost		$              6,476.00
Purchse cost	(500*13.28)	$              5,312.00

Since purchase cost of timing unit is less than manufacturing cost , Waterways should buy timing unit and manufacture small fitting  

small Fitting : Manufacture

Timing unit: Buy