Question

Oxford Engineering manufactures small engines. The engines are sold to manufacturers who install them in such products as lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier to supply the starter assembly used in these engines.

The starter assembly is currently manufactured in Division 3 of Oxford Engineering. Last year, Division 3 manufactured 132,000 starter assemblies, but over the next several years, it is expected that 161,000 assemblies will be needed each year. Total costs related to the starter assembly for last year were as follows:

Direct material	$132,960
Direct labor	$153,200
Total overhead	$408,000
Total	$824,160

Further analysis of overhead revealed the following information:

• $183,600 of total overhead was variable.
• $109,000 of the fixed overhead were allocated costs that will continue even if the production of the starter assembly is discontinued.

Tidnish Electronics, a reliable supplier, has offered to supply starter assembly units at $6.50 per unit. If the company buys the assembly from Tidnish, the vacated plant space could be used for storage and, in so doing, avoid $53,000 of outside storage charges currently incurred.

REQUIRED

By how much will Oxford Engineering's total profits change if they decide to buy the starter assembly from Tidnish Electronics instead of making it themselves?   (Note: if the buy costs are less than the make costs, enter the difference as a positive number; if the buy costs are more than the make costs, enter the difference as a negative number.)

Answer 1

Answer)

Calculation of Relevant cost to manufacture the Starter Assembly

Relevant cost to Manufacture	Amount (In $)
Cost to be incurred due to manufacture of Starter Assembly:
Direct Material (161,000 units X $ 1.0073 per unit)	162,175
Direct Labor (161,000 units X $ 1.1606 per unit)	186,857
Variable manufacturing overhead (161,000 units X $ 1.3909 per unit)	223,935
Avoidable fixed manufacturing overhead ($ 408,000 - $ 183,600 - $ 109,000)	115,400
Cost to be incurred due to manufacture of Starter Assembly	688,367

Therefore the relevant cost to manufacture 161,000 units of starter assembly is $ 688,367

Calculation of Relevant cost to buy the Starter Assembly from Outside Supplier

Relevant cost to Buy	Amount (In $)
Cost to be incurred due to purchase of Starter Assembly:
Purchase Price (161,000 units X $ 6.50 per unit)	1,046,500
Less: Benefit to be achieved from released capacity	53,000
Total Relevant cost to Buy Started Assembly from outside supplier	993,500

Therefore the relevant cost to buy 161,000 units of starter assembly from outside supplier is $ 993,500

Decision: From the perusal of above tables, it is evident that the relevant cost to buy 161,000 starter assembly (i.e. $ 993,500) is more than the relevant cost of manufacture (i.e. $ 688,367), if the company decides to the starter assembly from outside supplier, the net profit of the company will decrease by $ 305,133 (i.e. $ 993,500 - $ 688,367).

Working Note -1:

Calculation of cost per unit of Variable expenses

Particulars	Amount (In $)
Direct Material ($ 132,960/ 132,000 units)	1.0073
Direct Labor ($ 153,200/ 132,000 units)	1.1606
Variable manufacturing overhead ($ 183,600/ 132,000 units)	1.3909

Calculation of Avoidable Fixed cost

Avoidable fixed cost = Total fixed cost – variable fixed cost – allocated fixed overheads

                                      = $ 408,000 - $183,600 - $ 109,000

                                      = $ 115,400.

Note: Allocated fixed overhead is a sunk cost because it is apportioned to starter assembly and not incurred for it. Thus it should not be included in relevant cost to manufacture starter assembly.