Lamb Company manufactures several lines of machine products. One unique part, a valve stem, requires specialized tools that need to be replaced. Management has decided that the only alternative to replacing these tools is to acquire the valve stem from an outside source. A supplier is willing to provide the valve stem at a unit sales price of $20 if at least 70,000 units are ordered annually.

Lamb’s average usage of valve stems over the past 3 years has been 80,000 units each year.

Expectations are that this volume will remain constant over the next 5 years. Cost records indicate that unit manufacturing costs for the last several years have been as follows. mk55

If the specialized tools are purchased, they will cost $2,500,000 and will have a disposal value of $100,000 after their expected economic life of 5 years. Straight-line depreciation is used for book purposes. For tax purposes, the specialized tools are considered 3-year property; the applicable depreciation rates for the next 3 years are 25%, 38%, and 37%, respectively. The tools qualify for an investment tax credit of 4%. The company has a 40% marginal tax rate, and management requires a 12% after-tax return on investment.

The sales representative for the manufacturer of the new tools stated, ‘*The new tools will allow direct labor and variable overhead to be reduced by $1.60 per unit.’ Data from another manufacturer using identical tools and experiencing similar operating conditions, except that annual production generally averages 110,000 units, confirm the direct labor and variable overhead savings.

However, the manufacturer indicates that it experienced an increase in raw material cost due to the higher quality of material that had to be used with the new tools. The manufacturer indicated that its costs have been as follows:

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Direct material. Direct labor... Variable overhead. Fixed overhead" Total unit cost $ 3.80 3.70 1.70 4.50 $13.70 "Depreciation accounts for two- thirds of the fixed overhead The balance is for other fixed overhead costs of the factory that require cash expenditures