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 $40 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				18,000 Units Per Year
Direct materials	$	18		$	324,000
Direct labor		9			162,000
Variable manufacturing overhead		2			36,000
Fixed manufacturing overhead, traceable		9	*		162,000
Fixed manufacturing overhead, allocated		12			216,000
Total cost	$	50		$	900,000

*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 18,000 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 $180,000 per year. Given this new assumption, what would be financial advantage (disadvantage) of buying 18,000 carburetors from the outside supplier?

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

Answer 1

1.

	Make	Buy	Financial advantage (disadvantage) of Buying
Direct materials	324000	0	324000
Direct labor	162000	0	162000
Variable manufacturing overhead	36000	0	36000
Fixed manufacturing overhead, traceable	162000	108000	54000
Fixed manufacturing overhead, allocated	216000	216000	0
Purchase price (18000 x $40)	0	720000	-720000
Total $	900000	1044000	-144000

2. No

The outside supplier's offer should not be accepted since it would result in a financial disadvantage of $144000.

3.

	Make	Buy	Financial advantage (disadvantage) of Buying
Direct materials	324000	0	324000
Direct labor	162000	0	162000
Variable manufacturing overhead	36000	0	36000
Fixed manufacturing overhead, traceable	162000	108000	54000
Fixed manufacturing overhead, allocated	216000	216000	0
Opportunity cost	180000	0	180000
Purchase price (18000 x $40)	0	720000	-720000
Total $	1080000	1044000	36000

4. Yes

Troy Engines should accept the offer to buy the carburetors since it would result in a financial advantage of $36000.

Note: The allocated fixed manufacturing overhead of $216000 and the depreciation of special equipment 2/3 x $162000 = $108000 will continue irrespective of whether the carburettor is made or bought from the outside supplier.

The segment margin from the new product that would be lost if carburettors are made is the opportunity cost of making instead of buying.