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				22,000 Units per Year
Direct materials	$	15		$	330,000
Direct labor		8			176,000
Variable manufacturing overhead		3			66,000
Fixed manufacturing overhead, traceable		3	*		66,000
Fixed manufacturing overhead, allocated		6			132,000
Total cost	$	35		$	770,000

*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 22,000 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 $220,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 22,000 carburetors from the outside supplier?

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

Answer 1

The relevant cost of making is the total of avoidable costs

Fixed allocated costs will be incurred under both the alternatives and hence not relevant for this devision

1.Relevant cost per unit = 15+8+3+3*1/3

= 27 per unit

Disadvantage of buying from outside supplier = (35-27)*22,000

= $(176,000)

2.no, the offer should not be accepted since disadvantage

3.loss from outsourcing = $(176,000)

Add: segment margin from new product = $220,000

Net advantage = $44,000

4.yes, the offer should be accepted because of net advantage