Question

Troy Engines, Ltd., manufactures a variety of engines for use in heavy equipment. The company has always produced all of the necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of carburetor to Troy Engines, Ltd., for a cost of $35 per unit. To evaluate this offer, Troy Engines, Ltd., has gathered the following information relating to its own cost of producing the carburetor internally:

	Per Unit				16,000 Units Per Year
Direct materials	$	16		$	256,000
Direct labor		12			192,000
Variable manufacturing overhead		3			48,000
Fixed manufacturing overhead, traceable		3	*		48,000
Fixed manufacturing overhead, allocated		6			96,000
Total cost	$	40		$	640,000

*One-third supervisory salaries; two-thirds depreciation of special equipment (no resale value).

Required:

1. Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 16,000 carburetors from the outside supplier?

2. Should the outside supplier’s offer be accepted?

3. Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $160,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 16,000 carburetors from the outside supplier?

4. Given the new assumption in requirement 3, should the outside supplier’s offer be accepted?

Answer 1

1.financial advantage (disadvantage)

	Make option	Buy option
Direct Material [16,000 unit*$16]	$256,000
direct Labor[16,000*$12]	$192,000
Variable manufacturing OH [16,000*$3]	$48,000
Fixed manufacturing OH [$48,000*1/3]**	$16,000
Purchasing cost		$560,000[$35*16,000]
Total cost	$512,000[$256,000+192,000+48,000+16,000]	$560,000

** depreciation is a sunk cost. It is not relevant as it will remain same in both the situation

Financial disadvantage of buying from outside = $48,000[$512,000-$560,000]

Allocated fixed costs are constant and will remain same in both the situation.

2.No, offer should not be accepted as it will result into loss.

3.

	Make option	Buy option
Cost of purchasing		$560,000
cost of making	$512,000
opportunity cost -segment margin foregone on a potential new product line	$160,000
Total cost	$672,000	$560,000

There will be financial advantage of buying of $112,000 [$672,000-$560,000]

4. Yes the company shoudl buy carbeurators in this case.as it is resulting into profit of $112,000

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