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 $34 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				21,000 Units per Year
Direct materials	$	14		$	294,000
Direct labor		12			252,000
Variable manufacturing overhead		2			42,000
Fixed manufacturing overhead, traceable		9	*		189,000
Fixed manufacturing overhead, allocated		12			252,000
Total cost	$	49		$	1,029,000

*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 21,000 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 $210,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 21,000 carburetors from the outside supplier?

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

Answer 1

1.

Particulars	Make	Buy
Direct materials ( $14 * 21,000 )	$294,000
Direct labor ( $12 * 21,000 )	$252,000
Variable overhead ( $2 * 21,000 )	$42,000
Fixed manufacturing overhead, traceable ( $3 * 21,000 )	$63,000
Fixed manufacturing overhead, allocated	-
Purchase price from outside supplier ( $34 * 21,000 )	-	$714,000
Total cost	$651,000	$714,000

Financial advantage of producing the carburetors rather than buying from the outside supplier = Total cost of making - Total cost of purchasing = $714,000 - $651,000 = $63,000

*Fixed manufacturing overhead, traceable - Only the one third portion of $9 has been taken for the purpose of decision making as it is for supervisor's salary which is a relevant cost. If the company chooses to buy the product from the outside supplier then it will not incur this cost. However, Depreciation of special equipment has not been considered as it has zero resale value, so if the company decides to buy the product still there will be no use of the equipment.

** Fixed manufacturing overhead, allocated -  It has not been cosidered while evaluating the options as this cost is a sunk cost and it will be incurred no matter any option is chosen by the company. Therefore, its a irrelevant cost here.

2. The outside supplier's offer should not be accepted as it will result into losses for the company financially to the extent of $63,000.

3. Financial advantage of buying 21,000 carburetors from the outside supplier, if the freed capacity can generate additional income = Segment margin from the freed capacity - Financial advantage of producing the product = $210,000 - $63,000 = $147,000.

4. The outside supplier's offer should be accepted as can be seen in the answer 3 above, the acceptance of the offer will generate incremental revenues for the company.