Question

Ace Bicycle produces bicycles and manufactures all parts internally. Ace has received an offer from an outside vendor to supply all of the chains Ace requires at $8.20 per chain. Ace’s expected production for the year is 10,000 units. The following information relates to chain production:

Variable Costs: $7.50/unit, $75,000 total

Machine Rent: $5000

Other Fixed Costs: $30,000

Total Costs: $110,000

Suppose that if Ace buys the chains from the outside vendor, the factory where Ace used to make the chains could instead be used to upgrade the bicycles with higher quality chains. The upgrade would increase the selling price of the bicycles by $20, variable costs per unit by $18, and (fixed) tooling costs by $16,000.

1. Should Ace make or buy the chains?

2. What is the maximum price per chain Ace would be willing to pay to the outside vendor (so that they are indifferent between making and buying the chains)?

Answer 1

1. Make or Buy Decision ( Amount in $)

Particulars	Make	Buy
Variable Cost	75000 (7.5 * 10000)	82000 (8.2 * 10000)
Machine Rent	5000
Fixed Cost (Note a )	30000	30000
Total Cost	110000	112000
Less : Total Saving / Increase in revenue (Note b)		4000 ((20-18)*10000) - 16000
Net Cost	110000	108000

Since the net cost for buy decision is lower, ACE bicycle should go for buy decision.

Note :

a.The fixed will remain same for both the decisions because even if ACE bicycle decides to buy the fixed costs cannot be avoided.

b. If the Ace bicycle decides to Buy it can increase its selling price with some additional cost and therefore total saving is to be considered for finding net cost.

2. For indifference point, Ace bicycle can bear net cost upto $110000 for buy decision

Net Cost = Total Cost - Total Saving

$110000 = Total Cost - $4000

Total Cost = $114000

This Total cost = Variable Cost + Fixed Cost

So, $114000 = Variable Cost + $30000

Variable Cost = $84000

So maximum Price / Unit = $84000 /10000

= $8.40