The Rohr Company's old equipment for making subassemblies is worn out. The company is considering two alternatives:
a) Completely replacing old equipment with latest equipment
b) Buying sub-assemblies from a reliable outside supplier, who has quoted a unit price of 1$ on a seven-year contract for a minimum of 50 000 units per year.
Production was 60 000 units in each of past two years. Prospect needs for the next seven years are not anticipated to fluctuate outside the range of 50 000 to 70 000 units per year. Cost records for the past two years reveal the following unit costs of manufacturing the sub-assembly:
Direct material 0.30$
Direct labour 0.35$
Variable overhead 0.10$
Fixed overhead 0.25$
Total Unit Cost 1$
The fixed overhead comprises 0.10$ depreciation and 0.10 for direct departmental fixed overhead. The new equipment will cost 188 000$ and is expected to last seven years, at the end of that is estimated to have a disposal value of 20 000$. The current disposal value of old equipment is 10000$.
The sale representative for the latest equipment has indicated that the raise in machine speeds will reduce the total of direct labour and variable overhead by 0.35$ per unit. Consider last year's experience of one of your major competitors with identical equipment. They produced 100 000 units under operating conditions comparable to yours and showed the subsequent unit cost:
Direct material 0.30$
Direct labour 0.05$
Variable overhead 0.05$
Depreciation 0.24$
Other fixed overhead 0.16$
Total Unit Cost 0.80$
You have established that any idle facilities couldn’t be put to alternative use, and that 0.05$ per unit of the old Rohr unit cost is allocated fixed overhead that will be uninfluenced by decision.
1) The president asks you to compare the alternatives on a total-annual-cost basis and on a-per-unit basis for yearly needs of 60 000 units. Which alternative appears more attractive?
2) Would your answer change if the needs were at either end of relevant range (50 000 units and 70 000 units) Demonstrate at what volume level Rohr would be indifferent between making and outsourcing sub-assemblies.
3) What factors, other than the preceding ones, must you bring to the attention of management to aid them in making their decision? Include the considerations that may be applied to outside supplier.