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Making Make or Buy Decisions

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Make or Buy

The Smith Company's old equipment for making subassemblies is worn out. The company's considering 2 courses of action 1. replace the old equipment with new or 2. buying subassemblies from a reliable outside supplier who has quoted a unit price of $1 on a seven-year contract for a min. of 50,000 units per year.

Production was 60,000 units in each of the 2 past years. Future needs for the next seven years are not expected to fluctuate beyond 50,000 to 70,000 units per year. Cost records for the past two years reveal the following unit costs of manufacturing the subassembly:

Direct Material $ .30
Direct Labor .35
Variable overhead .10
Fixed Overhead .25
(including $.10 depreciation and .10 for direct departmental fixed overhead)
Total $1.00

The new equipment will cost $188,000 cash, will last 7 years and will have a disposal value of $20,000. The current disposal value of the old equipment is $10,000.

The sales rep. for the new equipment has summarized her position as follows: The increase in machine speeds will reduce direct labor and variable overhead by $.35 per unit. Consider last years experience of one of your major competitors with identical equipment. They produced 10,000 units under operating conditions very comparable to yours and showed the following unit costs.

Direct Material $.30
Direct Labor .05
Variable overhead .05
Fixed overhead (including .40
depreciation of .24)
Total $.80

For the purpose of this case assume any idle facilities cannot be put to alternative use. Also, assume that $.05 of the old Rohr unit cost is allocated fixed overhead that will be unaffected by the decision.

* I know the case is kind of long but here are two questions that go with it.......

1. The president asks you to compare the alternatives on a total-annual-cost basis and on a per-unit basis for annual needs of 60,000 units. Which alternative is more attractive?

2. Would the answer to requirement A. change if the needs were 50,000 units? 70,000 units? At what volume level would Rohr be indifferent between making and buying subassemblies?

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If the production is 60,000 units then the Direct Material would be @$.30 per unit, $18,000, the Direct Labor @$.05 per unit, $ 3,000 units, variable labor @$.05 per unit, $3,000 and Fixed Overhead @$.10 per unit, $6,000, Old unit fixed cost,$.0.5 per unit, $3,000 and yearly depreciation @$.40 per unit, $24,000.(Please note that the depreciation has been calculated as follows. $ 188,000 - $20,000 which gives us $168,000 and this is divided by seven years, which gives us $24,000) We have also ...

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