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 $35 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				17,000 Units per Year
Direct materials	$	17		$	289,000
Direct labor		8			136,000
Variable manufacturing overhead		4			68,000
Fixed manufacturing overhead, traceable		6	*		102,000
Fixed manufacturing overhead, allocated		9			153,000
Total cost	$	44		$	748,000

*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 17,000 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 $170,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 17,000 carburetors from the outside supplier?

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

Answer 1

Solution

Troy Engines Ltd

1. Determination of financial advantage (disadvantage) of buying 17,000 carburetors from the outside supplier, assuming no alternative use for facilities:

	Per unit Differential Costs	Total for 17,000 units
	MAKE	BUY	MAKE	BUY
Cost of purchasing	$35		$595,000
Direct materials	$17		$289,000
Direct labor	$8		$136,000
Variable MOH	$4		$68,000
Fixed MOH Traceable	$2		$34,000
Total costs	$31	$35	$527,000	$595,000

Note: The 2/3rd portion of traceable fixed manufacturing overhead is depreciation. This is a sunk cost and hence not relevant. The 1/3rd portion ($6 x 1/3= 2) relates to the supervisory salary, which is avoidable. Hence, a relevant cost.

The financial disadvantage of buying 17,000 carburetors from the outside supplier is $68,000.

(cost to buy – cost to make, 595,000 – 527,000 = $68,000)

2. Based on the above calculations, the cost to MAKE 17,000 units, $527,000 is lower compared to cost to BUY 17,000 units, $595,000 by $68,000. Hence the company should reject the order from outside supplier and continue production using the internal facilities.

3. Determination of financial advantage (disadvantage) of buying 17,000 carburetors from the outside supplier, assuming use for alternative facilities:

	MAKE	BUY
Cost of purchasing	$595,000
Cost of making	$527,000
Opportunity cost - segment margin foregone	$170,000
Total cost	$697,000	$595,000

The cost to buy, $697,000 is higher than the cost to buy $595,000 by $102,000.

The above computations indicate that total cost to MAKE is $102,000 higher compared to total cost to BUY. Hence, the company should accept the order from outside supplier and BUY the carburetor.      

Note: The total cost to make, $527,000 is already computed in part 1.

4. Yes, the company should accept the outside supplier’s offer for 17,000 units under the assumption that facilities have alternative use resulting in segment margin of $170,000.