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 $ 151,500 $ 80,800 $ 232,300 Less variable expenses 80,800 46,460 127,260 Contribution margin $ 70,700 $ 34,340 $ 105,040 Less direct fixed expenses* 20,200 38,380 58,580 Segment margin $ 50,500 $ (4,040) $ 46,460 Less common fixed expenses 30,300 Operating income $ 16,160 * Includes depreciation. The density gauge uses a subassembly that is purchased from an external supplier for $25 per unit. Each quarter, 2,020 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 $27,270 per quarter for the space and $10,100 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 $38,380, $8,080 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? Make the subassembly If it makes the subassembly, which alternative should be chosen? Drop the thickness gauge Enter the relevant costs of each alternative. Lease and Make Buy Drop Thickness Gauge and Make Total relevant costs $fill in the blank 3 $fill in the blank 4 $fill in the blank 5 2. Suppose that dropping the thickness gauge will decrease sales of the density gauge by 10 percent. What decision should now be made? Keep the thickness gauge and buy the subassembly 3. Assume that dropping the thickness gauge decreases sales of the density gauge by 10 percent and that 2,828 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

Answer:

1.

i) Lease the Place and Make the Subassembly : Total Relevant Costs =

Total Fixed Cost + Total Variable Costs = ($27,270+$10,100)+[(2+3+2) x 2,020] = 37,370 + 14,140 = $51,510

ii) Purchase Subassembly : Total Relevant Cost = $25 x 2,020 = $ 50,500

iii) Drop Thickness Gauge and Make Subassembly : Total Relevant Costs =

($38,380 - $8,080) + [(2+3+2) x 2,020] = $ 44,440

So the company should choose option iii ( i.e., Drop Thickness Gauge and Make Subassembly ) because the Total Relevant Costs of this option are low when compared with other options.

2. This is a case of Opportunity Cost. So, the loss occurred by a decrease in Sales should also be added to the Total Relevant Cost of option iii ( i.e., Drop Thickness Gauge and Make Subassembly ).

Therefore the New Total Relevant Cost of option iii = $44,440 + (10% of 151,500) = 44,440 + 15,150 = $59,590

Therefore, the company should choose option ii (i.e., Purchase Subassemble) because the Total Relevant Costs of this option is low when compared with other options.

3. This is also a case of Opportunity Cost.

The new Total Relevant Cost = Fixed Costs + Variable Costs + (10% of Sales Value of Density gauge)

= ($38,380 - $8080) + [(2+3+2) x 2,828] + (10% of 151,500) = 30,300 + 19,796 + 15,150 = $ 65,246

Therefore, the company should choose option ii (i.e., Purchase Subassemble) because the Total Relevant Costs of this option is low when compared with other options.