Question

Make-or-Buy, Traditional Analysis

Morrill Company produces two different types of gauges: a density gauge and a thickness gauge. The segmented income statement for a typical quarter follows.

	Density Gauge		Thickness Gauge		Total
Sales	$	169,500	$	90,400	$	259,900
Less variable expenses		90,400		51,980		142,380
Contribution margin	$	79,100	$	38,420	$	117,520
Less direct fixed expenses*		22,600		42,940		65,540
Segment margin	$	56,500	$	(4,520)	$	51,980
Less common fixed expenses						33,900
Operating income					$	18,080
* Includes depreciation.

The density gauge uses a subassembly that is purchased from an external supplier for $25 per unit. Each quarter, 2,260 subassemblies are purchased. All units produced are sold, and there are no ending inventories of subassemblies. Morrill is considering making the subassembly rather than buying it. Unit-level variable manufacturing costs are as follows:

Direct materials	$2
Direct labor	3
Variable overhead	2

No significant non-unit-level costs are incurred.

Morrill is considering two alternatives to supply the productive capacity for the subassembly.

Lease the needed space and equipment at a cost of $30,510 per quarter for the space and $11,300 per quarter for a supervisor. There are no other fixed expenses.

Drop the thickness gauge. The equipment could be adapted with virtually no cost and the existing space utilized to produce the subassembly. The direct fixed expenses, including supervision, would be $42,940, $9,040 of which is depreciation on equipment. If the thickness gauge is dropped, sales of the density gauge will not be affected.

Required:

1. Should Morrill Company make or buy the subassembly?

If it makes the subassembly, which alternative should be chosen?

Enter the relevant costs of each alternative.

	Lease and Make	Buy	Drop Thickness Gauge and Make
Total relevant costs	$	$	$

2. Suppose that dropping the thickness gauge will decrease sales of the density gauge by 10 percent. What decision should now be made?

3. Assume that dropping the thickness gauge decreases sales of the density gauge by 10 percent and that 3,164 subassemblies are required per quarter. As before, assume that there are no ending inventories of subassemblies and that all units produced are sold. Assume also that the per-unit sales price and variable costs are the same as in Requirement 1. Include the leasing alternative in your consideration. Now, what is the correct decision?

Answer 1

(1) Make or Buy the Subassembly :-

	Lease & Make	Buy	Drop Thickness Gauge & Make
Direct Material	2	-----	2
Direct Labour	3	-----	3
Variable O/H	2	-----	2
Equipment cost	(30510/2260) =13.5	-----	-----
Supervisor	(11300/2260) =5	-----	-----
Contribution lost due to drop of Thickness gauge	-----	-----	(4520/2260) =2
Direct Fixed Exp excluding Depreciation (42940-9040)	-----	-----	(33900/2260) =15
Purchase cost from outside supplier	-----	25	-----
	25.5	25	24

Contribution lost of Thickness Gauge :-

Sales	90400
(-) variable cost	51980
(-) Direct Exp excluding depreciation (42940–9040)	33900
Contribution lost due to drop of Thickness gauge	4520

Drop Thickness & Make Gauge is the best option due to least cost per unit

(2) Make or Buy the Subassembly :-

	Lease & Make	Buy	Drop Thickness Gauge & Make
	25.5	25	24
Contribution lost due to decrease sale of density gauge			(7910/2260) =3.5
	25.5	25	27.5

Contribution lost due to decrease sale of density gauge :-

Contribution lost 10% = 79100 * 10% =7910

Now Buy is the best option

(3) Make or Buy the Subassembly :-

	Lease & Make	Buy	Drop Thickness Gauge & Make
Direct Material	2	-----	2
Direct Labour	3	-----	3
Variable O/H	2	-----	2
Equipment cost	(30510/3164) =9.64	-----	-----
Supervisor	(11300/3164) =3.57	-----	-----
Contribution lost due to drop of Thickness gauge	-----	-----	(4520/3164) =1.43
Direct Fixed Exp excluding Depreciation (42940-9040)	-----	-----	(33900/3164) =10.71
Purchase cost from outside supplier	-----	25	-----
Contribution lost due to decrease sale of density gauge			(7910/3164) =2.5
	20.21	25	21.64

Lease & Make is the best option