Question

Moonstone Components Limited (MCL) was a medium-sized fabricator of various complex components for large industrial users. In recent years, MCL’s profits had been “squeezed” by cost increases causing management to examine new, potentially profitable ideas. One of the company’s production managers proposed that the company subcontract the manufacture of certain small, standard, high-volume-sub-components to outside producers. In support of the claim, the following unit cost data about a particular fitting called a “905 Connector” was provided:

         

          Direct Materials      $3.46

          Direct Labour           2.00

          Factory Overhead    2.20

                                        $7.66

MCL had used approximately 100,000 units of the “905 Connector” during the past year. The “905 Connector” was used in the construction of a large, heavy-duty unit. Other production costs for this valve unit amounted to $367.00. It sold for $480.00, with a sales representative commission of 5%.

Factory overhead was allocated at 110% of direct labour, according to data provided by the company’s cost accountant. Factory overhead included all production costs other than direct materials and direct labour, but did not include administrative expenses.

The manager pointed out that by subcontracting the production of the “905 Connector” an entire team of workers and one supervisor would no longer be required. The production supervisor and factory workers earned (including benefits) $44,000 and $200,000 per year, respectively. A small metal fabricating company guaranteed the production of the “905 Connector” to specifications at a unit price of $6.14 for any volume between 60,000 and 120,000 units.

REQUIRED:

1) Should Moonstone Components Limited subcontract the production of the “905 Connector”? Show computations.

2) At what level of volume would the company be indifferent between continuing to produce the “905 Connector” internally and subcontracting the production?

3) What qualitative factors should the company consider in determining whether it should make or subcontract the “905 Connector”?

Answer 1

1. It is better to Subcontract as result in cost saving of 196000.

Outsouring 905 Connector
Particular	Unit 100000
Cost Saving
Direct Material	346000
Direct Labour	200000
Factory Overhead	220000
Production Supervisor Salary	44000
Less: Purchase Cost	-614000
Net Cost Saving	196000

2. Indifference point = 0

Since, per unit cost is less in subcontracting plus there is saving of 44000 in supervisor salary. So, purchase of component is beneficial in any quantity.

3. Qualitative factors to be considered for subcontracting:

1. Reputation and reliability of Supplier

2. Quality of product

3. Expertise of production department

4. Social factors like employment