Question

11-40 Make or buy, unknown level of volume. (A. Atkinson, adapted) Denver Engineering manufac- tures 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 Denver Engineering. The costs relat- ing to the starter assemblies for the past 12 months were as follows:

Direct materials                                                  $550,000
Variable direct manufacturing labor $300,000

Manufacturing overhead $800,000
Total $1,650,000

Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each starter assembly is $10 ($1,500,000 / 150,000).

Further analysis of manufacturing overhead revealed the following information. Of the total manufac- turing 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 Denver Engineering 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.

1. Tutwiler Electronics, a reliable supplier, has offered to supply starter-assembly units at $8 per unit. Because this price is less than the current average cost of $10 per unit, the vice president of manufacturing is eager to accept this offer. On the basis of financial considerations alone, should Denver Engineering accept the outside offer? Show your calculations. (Hint: Production output in the coming year may be different from production output in the past year.)
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?

Answer 1

Direct Materials	550,000
Direct labors	300,000
Variable manufacturing overhead (800000*25%)	200,000
Total variable cost	1,050,000
Divided by: units	150,000
Variable manufacturing cost per unit	7

Part 1

Let's assume the number of units = X.

Using All cost data	Alternative 1	Alternative 2
	Make	Buy
Variable manufacturing costs	7X
Fixed general manufacturing overhead	300,000	300,000
Avoidable Fixed overhead	200,000
Division 2 manager’s salary	80,000	100,000
Division 3 manager’s salary	100,000
Purchase cost, if bought		8X
Total costs	7X + 680000	8X + 400000

Using ralevant cost	Alternative 1	Alternative 2
	Make	Buy
Variable manufacturing costs	7X
Fixed general manufacturing overhead
Avoidable Fixed overhead	200,000
Division 2 manager’s salary	80,000	100,000
Division 3 manager’s salary	100,000	-
Purchase cost, if bought		8X
Total ralevant costs	7X + 380000	8X + 100000

7X + 380000 = 8X + 100000
380000 - 100000 = 8X - 7X
X = 380000 - 100000 = 280000
Indifferent units =		280,000

If the units is more than indifferent units of 280000, then company should preffered to manufacture units.	Alternative 1	Make
If the units is less than indifferent units of 280000, then company should preffered to buy units from suppliers.	Alternative 2	Buy
If the units is equal to indifferent units of 280000, then company should indifferent between buying units and manufacturing units.		Indifferent

Part 2

7X + 480000 = 8X + 100000

480000 - 100000 = 8X - 7X

X = 480000 - 100000 = 380000

Indifferent units =		380,000
$100,000 of outside storage charges currently incurred is relevant.