Question

Part III: Process Selection

Merrimac Manufacturing Company has always produced a certain component part at 50AED per part with an annual fixed investment of 10,000AED. Although the business is making a modest profit now, Merrimac suspects that if it invests in new equipment, it could recognize a substantial increase in profits. The new equipment costs 25,000AED to purchase and install. Merrimac estimates that with the new equipment, it will costs 40AED to produce the component part.

1. If the estimated demand is less than 1000 parts, Merrimac should or not purchase the new equipment?
2. Would your decision change if Merrimac’s annual demand increased to 2000 parts? Increased to 5000 parts?
3. Knowing that customers will be charged 65AED per part and considering the new equipment, how many component parts will Merrimac has to produce to break even? You have to calculate the break-even point.

Answer 1

FOR OLD EQUIPMENT

Fixed cost = 10,000 AED

Variable cost per unit = 50 AED

Let Quantity produced = Q

Total Variable cost = 50Q

Total Cost = Fixed Cost + Variable Cost

Total cost = 10,000 + 50Q

FOR NEW EQUIPMENT

Fixed cost = 25,000 AED

Variable cost per unit = 40 AED

Let Quantity produced = Q

Total Variable cost = 40Q

Total Cost = Fixed Cost + Variable Cost

Total cost = 25,000 + 40Q

AT THE CROSSOVER POINT::

Total cost for old equipment = Total cost for new equipment

10,000 + 50Q = 25,000 + 40Q

10Q = 15,000

Q = 1,500 units

This Q = 1500 units denotes that the company must use old equipment when quantity is less than 1,500 units because below 1500 units, the total cost using old equipment will be less and should buy new equipment when quantity is more than 1,500 units because for quantity greater than 1500 units, total cost using new equipment will be less.

(A)

If demand is less than 1000 units, the company should not buy new equipment.

(B)

If the demand is Increased to 2000 or 5000 units, the company should buy new equipment.

(C)

Selling price per unit using new equipment (S.P.) = 65 AED

Variable cost per unit using new equipment (V.C.) = 40 AED

Total fixed cost for new equipment = 25,000 AED

Break even components = Total fixed cost/(S.P. - V.C.)

Break even components = 25,000 / (65 - 40)

Break even components = 1,000 units

The company must produce 1,000 units to break even when using new equipment.