Question

Question
One of the divisions within Forth Motors is currently negotiating with another supplier
regarding outsourcing component A that it manufactures. The division currently
manufactures 10,000 units of the component per year. The costs currently assigned
to the component are as follows:
Total Costs of
producing 10,000
units of component
A (£)
Unit Cost (£)
Variable Costs
Material X 120,000 12
Labour 100,000 10
Other variable manufacturing
costs (power and utilities)
10,000 1
Fixed Costs
Fixed manufacturing costs 80,000 8
Share of fixed nonmanufacturing
costs
50,000 5
TOTAL COSTS 360,000 36
The above costs are expected to remain unchanged in the foreseeable future if Forth
Motors’ division continues to manufacture component A. The supplier has offered to
supply 10,000 units of component A per year at a price of £30 per unit guaranteed for
a minimum of 3 years. If Forth Motors outsources component A, the labour force
currently employed in producing the component will be made redundant. No
redundancy costs will be incurred. Material X and other variable manufacturing costs
(i.e. power and utilities) are avoidable if component A is outsourced. Fixed
manufacturing costs (some of which are stepped-fixed costs) would be reduced by
10,000 per year, but the share of the fixed non-manufacturing costs would remain
unchanged.


Required:
(a) Assume that the capacity that is required for component A has no alternative use.
Should the division of Forth Motors make or buy the component? Provide clear
workings and arguments to support your answer.

(b) Assume that the extra capacity that will be made available from outsourcing
component A can be used to manufacture and sell 10,000 units of component Z
at a price of £34 per unit. All of the labour force required to manufacture
component A would be used to make component Z. The other variable
manufacturing costs, the fixed manufacturing costs and the share of the fixed nonmanufacturing
costs would be the same as the costs incurred to manufacture
component A. Material X used to manufacture component A would not be
required, but additional Material Y required for making component Z would cost
£13 per unit. Should Forth Motors outsource component A? Provide clear
workings and arguments to support your answer.

Answer 1

(a)
					$	$
	Cost to buy		(10000*30)			300000
	Less:Savings in cost due to buying
	Material X				120000
	Labor				100000
	Other variable manufacturing costs				10000
	Fixed manufacturing costs				10000	240000
	Incremental cost					60000
	The division of Forth Motors should make the component since there is an incremental cost of $ 60000
(b)						$	$
	Cost to buy		(10000*30)				300000
	Less:Savings in cost due to buying
	Material X					120000
	Contribution margin from component Z				(Note:1)	100000
	Fixed manufacturing costs						220000
	Incremental cost						80000
	Forth Motors should not outsource component A since there is an incremental cost of $ 80000
	Note:1
					$	$
	Sales revenue			(10000*34)		340000
	Less: Variable costs
	Material Y			(10000*13)	130000
	Labor				100000
	Other variable manufacturing costs				10000	240000
	Contribution margin					100000