5 Suppose CP Manufacturing currently owns a machine that can

5. Suppose CP Manufacturing currently owns a machine that can produce a component needed for its product. Suppose each unit of CP’s product requires one unit of the component. CP typically needs 1,000 units of this component in production each year. The costs of making the component are

Direct material used in each unit $ 8

Variable manufacturing overhead for each unit 5

Direct labor utilized for each unit 10

Fixed overhead cost of maintaining the machine on a per unit basis 4

(a) Suppose an outside supplier ABC offers to sell CP this component at a price per unit of $30. If CP accepts this offer, it will not make the component in-house although it still possesses the

machine. Should CP accept this offer and buy the components from ABC or continue to make the components in-house, based on its current requirements?

(b) Suppose, CP does some market research and discovers that in case it decides to purchase its required components from outside, it can rent the service of the machine out to another

company XYZ who agrees to pay $5000 per year. CP must still maintain the machine in its

premises. What should be CP’s decision in this case – should it buy the components from ABC or should it make them in-house?

(c) Now, imagine CP negotiates with XYZ and gets XYZ to agree to cover the maintenance cost of the machine when it rents the machine from CP. Assuming everything else is the same as in (a) and (b) above, what is CP’s decision in this case -- should it buy the components from ABC or should it make them in-house?

Solution

a. Marginal Cost of manufacturing the component :

The cost of manufacturing cost id $23 whereas buying it from a outside is $30. Also, the company has to continue to incur $4 on fixed costs for machinery. Therefore the company should manufacture instead of buying it since manufacturing the component is cheaper.

(b) If the company rents out machine , then the net cost of buying the component = (30*1000) - 5000 = $25,000

If it manufactures in house , the marginal cost of manufacturing is = 23*1000 = $23,000

The company should reject this offer since manufacturing in house is cheaper than renting the machine and purchasing from a supplier.

(c) The negotiated price after covering fixed cost of maintenance = $30- $4 = $26.

This should also be rejected as the cost of manufacturing is more cheaper than buying it from the supplier.