Question

SM manufactures small engines that it sells to manufacturers who install them in products such as lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier who wishes to supply the starter assemblies used in these engines.

The starter assemblies are currently manufactured in Division 3 of SM. The costs relating to the starter assemblies for the past 12 months were as follows:

Direct materials	$400,000
Manufacturing labour	300,000
Manufacturing overhead	800,000
Total	$1,500,000

Over the past year, Division 3 manufactured 150,000 starter assemblies.

Further analysis of manufacturing overhead revealed the following information:

Of the total manufacturing overhead, only 25% is considered variable. Of the fixed portion, $300,000 is an allocation of general overhead that will remain unchanged for the company as a whole if production of the starter assemblies is discontinued. A further $200,000 of the fixed overhead is avoidable if production of the starter assemblies is discontinued. The balance of the current fixed overhead, $100,000, is the division manager’s salary. If SM discontinues production of the starter assemblies, the manager of Division 3 will be transferred to Division 2 at the same salary. This move will allow the company to save the $80,000 salary that would otherwise be paid to attract an outsider to this position.

Required

1. Good Supply, a reliable supplier, has offered to supply starter-assembly units at $8 per unit. Because this price is less than the current average cost per unit, the vice president of manufacturing is eager to accept this offer. On the basis of financial considerations alone, should SM accept the outside offer assuming that production remains consistent with the past year? Show your calculations.

2. How, if at all, would your response to requirement 1 change if the company could use the vacated plant space for storage and, in so doing, avoid $100,000 of outside storage charges currently incurred? Why is this information relevant or irrelevant?

3. Assume that demand increases and SM requires 190,000 units. On the basis of financial considerations alone, should SM accept the outside offer? Show your calculations.

Answer 1

Be careful while reading amounts (with commas).