Question

Santana Inc. manufactures widgets.  The end product is produced in different departments within the plant.  One component, C1, is causing some concern.  The component is integral to the production of widgets, but is readily available in the marketplace.  The machine used to produce the component is nearing the end of its useful life and management is trying to decide whether to replace it or outsource the supply.

The current manufacturing costs of the C1 are as follows:

Direct materials		$20.25	per unit
Direct Labor		$16.00	per unit
Variable manufacturing overhead		$8.00	per unit
Variable general Administration		$7.00	per unit
Other costs related to C1 Department:
Supervision		$240,000	per year
Amortization		$360,000	per year
General Administration		$400,000	per year

The plant can produce 100,000 units per year.  It needs 65,000 units of C1 for widget production and sells 20,000 units externally at a price of $71.00. It incurs variable selling costs of $4.00 per unit when it sells C1 externally. Their policy is to fulfil internal requirements first, then sell C1 externally.

Pluto Corporation has approached Santana with a proposal to produce C1 for them.  The cost would be $69.00 per unit.  Pluto guarantees on-time delivery and has agreed to a penalty of 25% of revenue on any late shipments.  Pluto has further agreed to provide up to 90,000 units per year and has guaranteed the price of $69.00 for the entire five year contract.

Santana can purchase a new machine to replace the existing equipment used to produce C1 for $4,600,000.  It is anticipated the new machine will result in labour cost savings of 10%.  All other costs will remain the same.  The new machine’s useful life is expected to be 5 years and its residual value at that time will be $150,000.  It will be classified as a class 8 asset for tax purposes, with a CCA of 20%.  The capacity of this new machine will be 100,000 units per year.  The corporate tax rate is 40% and the company requires a 10% return, after tax, on this investment.

Management of Santana asked its marketing research group to determine the anticipated demand for widgets over the next 5 years.  Management also asked the group to determine whether the excess capacity could be used to produce C1 for external sales.

The marketing group reported the following information:

1. Demand for widgets will be approximately 65,000 per year for the next three years, and will increase to 70,000 in years 4 and 5.
2. The company expects external sales will be 18,000 units per year for the first three years and will increase to 25,000 units per year for the last two years.

                        

Management estimates that 40% of the supervisory costs and $100,000 of general administration expenses would be eliminated if the C1 were outsourced.  

Management also feels that there will need to be modifications to the design of the C1 in future years in order for the widget to remain competitive.  The machine’s manufacturer has assured Santana management that the changes will be possible at virtually no change in cost.  Pluto Corporation has indicated that any design changes would incur additional costs for Santana.

Required:

Assume that you have been hired by Santana Inc. to determine whether the company should buy the new machine or outsource production of C1.  Prepare a quantitative analysis, and evaluate any qualitative factors that will be relevant to the decision.  Provide a recommendation for management.

Answer 1

If the machinery is purchased.

	Year 1	2	3	4	5
Direct materials	1680750	1680750	1680750	1923750	1923750
direct labour	1195200	1195200	1195200	1368000	1368000
Variable Manufacturing Over head	664000	664000	664000	760000	760000
Variable general Admin	581000	581000	581000	665000	665000
Suoervision	240000	240000	240000	240000	240000
General Admin	400000	400000	400000	400000	400000
Total expenses	4760950	4760950	4760950	5356750	5356750
Sales Externally(Net price 71-4)	1206000	1206000	1206000	1675000	1675000
Net Expenses	3554950	3554950	3554950	3681750	3681750
Amortization (allowed as per CCA)	460000	414000	372600	670680	536544
Total expenses as allowed for taxation Purposes	4014950	3968950	3927550	4352430	4218294
Additional Amortization For Financial reporting Purpose	430000	476000	517400	219320	353456
Total Expenses as per Financial Reporting	4444950	4444950	4444950	4571750	4571750

When outsourced.

C1 purchase Price	4485000	4485000	4485000	4830000	4830000
Supervision Expenses	144000	144000	144000	144000	144000
General Admin	300000	300000	300000	300000	300000
Total Expenses	4929000	4929000	4929000	5274000	5274000

It can be clearly seen that the material is outsourced the expenses occured are more even though the amortization as per the cca laws for taxation or expenses is as per financial reporting guidelines.

Other than this qualitative research let's see some qualitative factors also.

It can be clearly seen that the capacity of production in machinery is more than what is being produced. So if the sales forecast can exceed to what is being presented the machinery would be able to deliver even better.

Also if the C1 designed is to be altered for future purposes it can be done without incurringf any extra charges where in external outsourching redisgn will cost extra as per terms and conditions.

Hence the management is recommended to go for and buy a machinery for present as well as future Purpose.