Make or Buy Analysis [LO3]

“That old equipment for producing subassemblies is worn out,” said Paul Taylor, president of Timkin Company. “We need to make a decision quickly.” The company is trying to decide whether it should rent new equipment and continue to make its subassemblies internally, or whether it should discontinue production of its subassemblies and purchase them from an outside supplier.

The alternatives follow:

Alternative 1: Rent new equipment for producing the subassemblies for $60,000 per year.

Alternative 2: Purchase subassemblies from an outside supplier for $8 each.

Timkin Company’s current costs per unit of producing the subassemblies internally (with the old equipment) are given below. These costs are based on a current activity level of 40,000 subassemblies per year:

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2.75 Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.00 Variable overhead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.60 Fixed overhead ($0.75 supervision, $0.90 depreciation, and $2 general company overhead) . . . . . . . . . . . . . . . . . . . . . 3.65 Total cost per unit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11.00 The new equipment would be more efficient and, according to the manufacturer, would reduce direct labor costs and variable overhead costs by 25%. Supervision cost ($30,000 per year) and direct materials cost per unit would not be affected by the new equipment. The new equipment’s capacity would be 60,000 subassemblies per year.
The total general company overhead would be unaffected by this decision.
Required:
1. The president is unsure what the company should do and would like an analysis showing the unit costs and total costs for each of the two alternatives given above. Assume that 40,000 subassemblies are needed each year. Which course of action would you recommend to the president?
2. Would your recommendation in (1) above be the same if the company’s needs were ( a ) 50,000 subassemblies per year, or ( b ) 60,000 subassemblies per year?
3. What other factors would you recommend that the company consider before making a decision?