Question

Case 9-2 Sergo Games [LO 1, 3]

Sergo Games produces a variety of action games including a flight simulation game, Airport 10, which sold more than 800,000 copies in the past year. The programs are run on computers, and the company operates an in-house production facility that manufactures and packages CDs for shipment to customers.

            In 2017, the production plant prepared 2,600,000 CDs and incurred the following costs:

Units processed	2,600,000
Labor	$     900,000
Material	4,800,000
Supervisory salaries	350,000
Depreciation of equipment	420,000
Heat, light, phone, etc.	200,000
Total	$ 6,670,000

                                               

                       

Leslie Eastman, an accounting manager, has been given the responsibility to analyze outsourcing the production of CDs. Her report is provided below.

REQUIRED

Should the production of CDs be outsourced? Unlike Leslie, support your answer with appropriate calculations.

Sergo Games

April 19, 2018

TO: Shane Santiago, CFO

FROM: Leslie Eastman

SUBJECT: Outsourcing CD productions

In 2017, total production and packaging costs were $6,6700,000 or $2.57 per CD. The low-cost outside bidder for this business was XLS. They are a highly respected firm, and their offer is $3.52 per CD. Although the savings related to outsourcing is only $0.05 per CD, with annual production of 2,600,000 units, this amounts to $130,000 per year. The present value with a five-year horizon and an 11 percent cost of capital is $480,467. Thus, I recommend that we outsource CD productions.

            You asked me to determine the selling price of the production equipment. I had a representative of XLS walk through the facility. In his opinion, the equipment is dated, and he believes that the market value is essentially zero. At any rate, his company is not interested in purchasing the equipment even if we select them as a supplier. If we outsource, I do not believe that we can use the production facility for another purpose. As you know, the building is run down, and it’s not suitable space even for programmers!

            Finally, I want to mention another aspect of the problem that enhances the appeal of outsourcing. We currently have equipment with a book value of $2,000,000 and an average remaining value of 5 years. This generates approximately $400,000 per year of depreciation. If we outsource, we’ll have a $2,000,000 tax loss, which will save us approximately $700,000 (assuming a 35 percent tax rate). Thus, the total value of outsourcing is $1,180,467 (i.e., $480,467 + $700,000).

            Please call me if you have any questions regarding my analysis.

Answer 1

Leslie made a mistake in calculation of net cash outflow In the First paragraph , depreciation on equipment is a non cash expense and should be used for tax benefit purpose in calculation . Moreover , the offer for outsourcing is 3.52$ per CD , which is way higher than in house production cost . Savings figure of 0.05$ is wrong . In the third paragraph , depreciation should also be at discounted Present value instead of absolute value for better calculation and understanding. Depreciation figure is considered 400000 in 3rd paragraph whereas in the table above it is 420000.

Lets calculate the annual cash outflow :-

Labour + material + salary+ heat, light - (tax rate)depreciation on equipment  = 900000 + 4800000 + 350000 + 200000 - (0.35)420000 = 6103000

Cost per unit = total cost / no. of units = 6103000/ 2600000 = 2.34

Even if the outsourcing agency is offering 2.52$ per CD , it is expensive as compared to in house cost of 2.34$ per CD.