P2 A supplier could provide a component part for 7 per unit

P2. A supplier could provide a component part for $7 per unit. Your firm estimates $15,000 to prepare the contract with the supplier. To make the part in house, your firm must invest $105, 000 in capital and it will cost $5 to make the part. (a) (2 pts) What is the break even quantity? (b) (2 pts) If the annual requirement for the component part is 40,000 units, which option should be selected? Explain.

Solution

(a) Breakeven quantity = (capital investment to make - Cost to prepare the contract with supplier) / (Purchase cost per unit - Variable cost to make)

= (105000 - 15000)/(7-5)

= 45,000 units

Which means, it requires a volume of at least 45,000 so that Make option is more economical.

(b) Annual requirement of 40,000 is less than the breakeven quantity of 45000. Therefore, at this volume, Purchase option should be selected, because total cost of purchase option is lesser compared to make option. This can be cross-checked by calculating the total cost of both options (Total cost of Purchase = 15000 + 40000*7 = 295000, Total cost of Make = 105000 + 40000*5 = 305000)