Question

The division currently selling 12,000 units at $350 per unit. The direct variable cost of the product is broken down into two parts. $127 per unit is made in house and the remaining $62 per unit is outsourced. The fixed cost is $1,356,000.

As a manager of the division you have an opportunity to purchase equipment that will eliminate outsourcing the portion of the product. The current in house portion of making the product will stay the same at $127/unit. However, with the new machine and by making it in-house you will be able to cut the cost of the outsourced portion in half. Fixed costs will increase by $341,000 per year. (Depreciation being part of that cost) With the cost savings the product price will be able to be lowered to $330 per unit - the $20 price decrease will result in 10% increase in sales units over the $350 price.

The cost of the equipment is $1,575,000 with a salvage value of $5,000. The cost will be depreciated over five years using straight-line method. The machine will be paid off in 5 years, $1,000,000 the first year and the remainder paid off equally over years 2 through 5.

The following year, year 1 sales are expected to rise by 1,000 and increase by 1,000 units every year thereafter. With the purchase of the equipment the interest expense is scheduled to be the following. Note interest expense is included in the fixed expenses of the make scenario.

Year 1 $94,500

Year 2 $34,500

Year 3 $20,700

Year 4 $13,800

Year 5 $6,900

Average total assets

Buy: $6,500,000

Make: $7,287,500

Compare buy vs make over five years by calculating each of the methods below.

2. Net Present Value using 9.19% for DCF

Answer 1

NPV as per Make - $ 2229120

NPV as per BUY - $ 3396068

Decision : Buy Equipment