Drumbo Engineering manufactures small engines. The engines are sold to manufacturers who install them in products like lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier who has offered to supply a starter assembly used in these engines.
The starter assembly is currently manufactured in Division 3 of Drumbo Engineering. The costs relating to Division 3 for the past 12 months were:
Direct materials
$175,000
Direct labour
125,000
Manufacturing overhead
350,000
Total
$650,000
Over the past year, Division 3 manufactured 165,000 starter assemblies. Therefore, the average cost of a starter assembly is computed as $4 ($650,000 / 162,500).
Further analysis of manufacturing overhead revealed the following information. Of the total manufacturing overhead reported, 20% is variable. Of the fixed portion, $140,000 is an allocation of general factory overhead that would remain unchanged for the company as a whole if production of the starter assembly is discontinued. A further $60,000 of the manufacturing overhead is avoidable if the self-manufacture of the starter assembly division is discontinued.
The balance of the fixed overhead, $80,000 is the division managers salary. If the selfmanufacture of the starter assembly division is discontinued, the manager of Division 3 would be transferred to Division 2 at the same salary. The move would allow the company to save the $65,000 that would otherwise be paid to attract an outsider to this position.
Required:
a. Simcoe Electronics, a reliable supplier, has offered to supply starter assembly units at $3.50 per unit. Since this is less than the current average cost of $4 per unit, the vice president of manufacturing is eager to accept this offer. Should the outside offer be accepted? (Hint:
Production output in the coming year may be different from production output last year.)
b. How, if at all, would your respond to part a) change if the company could use the vacated plant space for storage and, in so doing, avoid $40,000 of outside storage charges currently incurred? Why is this information relevant or irrelevant?