The Assembly Division of American Car Company has offered to purchase 90,000 batteries from the Electrical Division of American Car for $100 per unit. At a normal volume of 250,000 batteries per year, production costs per battery are as follows:
Direct materials
$ 40
Direct manufacturing labor
20
Variable factory overhead
12
Fixed factory overhead
40
Total
$112
The Electrical Division has been selling 250,000 batteries per year to external buyers at $136 each; practical capacity is 340,000 batteries per year. If Assembly Division does not buy internally, then it will buy batteries from external sources for $130 each.
Will Electrical Divisionâs total operating income be higher or lower if it accepts the offer from Assembly Division? By how much?
Will American Car Companyâs total operating income be higher or lowerâand by how muchâif Electrical Division accepts the offer, rather than rejecting it and forcing Assembly Division to buy the batteries from external sources?
Now suppose that Electrical Division has created a new product. Demand for this product would be sufficient to occupy the capacity which has been unused in the recent past and which might be used to supply batteries to Assembly. Electrical could produce and sell 90,000 units of this new product to external customers for a price of $98 per unit without reducing its current external battery sales of 250,000 units or changing its total fixed costs. Variable manufacturing costs for the new product would be $54 per unit. Is it better for American Cars if (a) Electrical Division makes the new product or (b) it uses the capacity to produce batteries for Assembly Division? By how much would American Carâs total contribution margin differ depending on whether (a) or (b) is chosen?
Given the information in question 3, what is the maximum transfer price that Assembly Division would be willing to pay and the minimum transfer price that Electrical Division would be willing to accept for the batteries?
If the division managers of the two divisions are left to negotiate the price, then is it likely that they will make the decision about internal trade that is best for American Cars? Explain briefly.
The Assembly Division of American Car Company has offered to purchase 90,000 batteries from the Electrical Division of American Car for $100 per unit. At a normal volume of 250,000 batteries per year, production costs per battery are as follows:
| Direct materials | $ 40 |
| Direct manufacturing labor | 20 |
| Variable factory overhead | 12 |
| Fixed factory overhead | 40 |
| Total | $112 |
The Electrical Division has been selling 250,000 batteries per year to external buyers at $136 each; practical capacity is 340,000 batteries per year. If Assembly Division does not buy internally, then it will buy batteries from external sources for $130 each.
Will Electrical Divisionâs total operating income be higher or lower if it accepts the offer from Assembly Division? By how much?
Will American Car Companyâs total operating income be higher or lowerâand by how muchâif Electrical Division accepts the offer, rather than rejecting it and forcing Assembly Division to buy the batteries from external sources?
Now suppose that Electrical Division has created a new product. Demand for this product would be sufficient to occupy the capacity which has been unused in the recent past and which might be used to supply batteries to Assembly. Electrical could produce and sell 90,000 units of this new product to external customers for a price of $98 per unit without reducing its current external battery sales of 250,000 units or changing its total fixed costs. Variable manufacturing costs for the new product would be $54 per unit. Is it better for American Cars if (a) Electrical Division makes the new product or (b) it uses the capacity to produce batteries for Assembly Division? By how much would American Carâs total contribution margin differ depending on whether (a) or (b) is chosen?
Given the information in question 3, what is the maximum transfer price that Assembly Division would be willing to pay and the minimum transfer price that Electrical Division would be willing to accept for the batteries?
If the division managers of the two divisions are left to negotiate the price, then is it likely that they will make the decision about internal trade that is best for American Cars? Explain briefly.
Related questions
Mountain Air Limited manufactures a line of room air purifiers. Management is currently evaluating the possible production of an air purifier for automobiles. Based on an annual volume of 10,000 units, the predicted cost per unit of an auto air purifier follows.
| Direct materials | $ 9.00 |
| Direct labor | 1.40 |
| Factory overhead | 10.00 |
| Total | $ 20.40 |
These cost predictions include $80,000 in fixed factory overhead averaged over 10,000 units.
The completed air purifier units include a battery-operated electric motor, which Mountain Air assembles with parts purchased from an outside vendor for $2.00 per motor. Mini Motor Company has offered to supply an assembled battery-operated motor at a cost of $5.50 per unit, with a minimum annual order of 5,000 units. If Mountain Air accepts this offer, it will be able to reduce the variable labor and variable overhead costs of the auto air purifier by 50 percent.
(a) Determine whether Mountain Air should continue to make the electric motor or outsource it from Mini Motor Company.
Calculate the net advantage (disadvantage) of outsourcing the electric motors from Mini Motor Company.
Use a negative sign with your answer to indicate a net disadvantage (if applicable.)
$Answer
(b) If it could otherwise rent the motor-assembly space for $25,000 per year, should it make or outsource this component?
Calculate the net advantage (disadvantage) of outsourcing the motors, assuming the space could be rented.
Use a negative sign with your answer to indicate a net disadvantage (if applicable).
$Answer
(c) What additional factors should it consider in deciding whether to make or outsource the electric motors?
The quality of their own and the supplier's motors.
The dependability of the supplier.
Whether Mini Motor has a track record of meeting its commitments.
Whether they can depend on Mini Motor to supply motors for a number of years or whether it is attempting to use some temporarily idle capacity.
All of these.
Mountain Air Limited manufactures a line of room air purifiers.Management is currently evaluating the possible production of anair purifier for automobiles. Based on an annual volume of 10,000units, the predicted cost per unit of an auto air purifierfollows.
| Direct materials | $8.00 |
| Direct labor | 1.50 |
| Factory overhead | 6.00 |
| Total | $15.50 |
These cost predictions include $50,000 in facility-level fixedfactory overhead averaged over 10,000 units.
One of the component parts of the auto air purifier is abattery-operated electric motor. Although the company does notcurrently manufacture these motors, the preceding cost predictionsare based on the assumption that it will assemble such a motor.Mini Motor Company has offered to supply an assembledbattery-operated motor at a cost of $3.50 per unit, with a minimumannual order of 5,000 units. If Mountain Air accepts this offer, itwill be able to reduce the variable labor and variable overheadcosts of the auto air purifier by 50 percent. The electric motor'scomponents will cost $2.00 if Mountain Air assembles themotors.
(a) Calculate the net benefit (cost) of outsourcing the electricmotors from Mini Motor Company.
$Answer
(b) Calculate the net benefit (cost) of outsourcing the electricmotors from Mini Motor Company, assuming the motor-assembly spacecould be rented to another company for $21,000 per year.
$Answer
(c) Management should consider which of the followingnonquantitative factors in deciding whether to make or buy themotors.
A.)The quality of their own and the supplier's motors.
B.)The dependability of the supplier.
C.)Whether Mini Motor has a track record of meeting itscommitments.
D.)Whether they can depend on Mini Motor to supply motors for anumber of years or whether it is attempting to use some temporarilyidle capacity.
E.)All of these.
INSOURCING/OUTSOURCING
Rentex Motor Drives is a division of a large U.S. manufacturer of industrial machinery and equipment. The parent company makes circulating pumps, high-capacity cooling fans, and compressors. Rentex Motor Dnves manufactures the electric motors that power much of this machinery and equipment. Rentex has a world-wide customer base and sells motors not only to its parent company, but also to other customers across the globe â some of whom are direct competitors of Rentex's parent company.
Recently the company developed an electric motor assembly that will be a key component in a new circulating pump being manufactured and sold by one of Rentex's sister companies. The circulating pump will be sold to the manufacturers of oil-fired burners used for home heating. Each circulating pump will require a single electric motor assembly.
Rentex must now decide whether or not it should outsource or internally manufacture the motor assembly. To help with the analysis, a cross-functional team has been formed. Members of the team have been assigned the responsibility of analyzing from a total cost perspective whether or not Rentex should outsource or internally manufacture the electric motor assembly.
A European supplier that produces motors for a number of Fortune 500 companies has submitted a detailed proposal to Rentex for building the subassembly. However, confounding this analysis is an internal bias against outsourcing the motor, particularly since there is a strong union presence within Rentex's facilities. Furthermore, management at Rentex believes that the electric motor assembly design might be adapted in the future to enable its use in new applications in the chemical processing industry, thereby representing a future growth opportunity.
As an initial step the cross-functional team has gathered the required information to guide the firm's decision process.
Outsourcing Costs
Unit Costs: Rentex's marketing group estimates that volumes for the motor assembly are:
| Year 1 | 5,500 units |
| Year 2 | 6,250 units |
| Year 3 | 7,000 units |
The European supplier of electric motors has quoted a price of $105 per unit, FOB ex-works, 1&2 with 5% price decreases per year for Year 2, and again for Year 3. Remember â the Year 3 price decrease is based off the Year 2 figure). The team assumes these price decreases are due to productivity improvements from higher volumes, the positive effects of learning at the supplier, and greater operating efficiencies. These prices have not been negotiated and the purchasing team believes that negotiation may lead to a lower unit price. If the new line of circulating pumps is successful, it is estimated that the life of the product cycle will be six years, reaching a peak of 8,000 units in Year 4, with a 10% reduction per year in volume after that as the product reaches the end of its life. It is estimated that the product will be completely phased out at the end of Year 6.
Shipping, handling, and receiving: Shipping, handling, and receiving costs at the buyer are estimated to be $15 per unit and should remain constant.
Tooling: The supplier has stated that it will cost $30,000 to fabricate the tooling and fixtures required to produce the electric motor. Rentex's policy is to assume ownership of tooling, so Rentex is responsible for the tooling costs. It's estimated that the tooling will have a usable life span of at least 6 years, with proper preventive maintenance (which the supplier has agreed to perform at no additional cost). The purchasing team plans to allocate the tooling costs evenly over the first three years.
Quality-related costs: The team has decided to include quality-related costs in its outsourcing calculations. During the investigation of the supplier, a team member collected data on the process that would likely produce the motors. The team estimates that the supplier's defect level, based on process measurement data, is 1,000 parts per million (ppm). Rentex's quality assurance department estimates that each supplier defect will cost Rentex $1,750 in direct nonconformance costs. Unfortunately, with quality problems there are always hidden costs that are difficult, if not impossible, to model.
Supplier capacity/safety stock: The team has concluded the supplier has available capacity to satisfy Rentex's current and near-term requirements for the motor. To mitigate supply chain risk, Rentex plans to hold one month's worth of the assembly as safety stock. The team assumes that this is a new cost each year.
Insourcing Costs
Rentex's cost engineering department has provided the following per unit cost estimates for internally manufacturing and assembling the motors during Year 1 of a three-year planning cycle:
| Direct labor | $19.75 | Cost of receiving components | $4.25 |
| Direct materials | $35.25 | Supplemental factory supplies | $2.15 |
| Transfer profit 3 | $21.75 |
Initial tooling and line modification costs: The start-up costs (including tooling) to modify existing production lines and equipment to accommodate production of the new motor will be $42,000, which will be spread out evenly over the first three years.
Depreciation expense: Depreciation expense on production equipment and tooling is considered a noncash item and is not included in the insourcing analysis.
Engineering design costs: Engineering costs to design, develop, and improve the production process will be $75,000 and will be spread evenly across the first three years of production.
Factory and corporate overhead: Overhead is allocated at 180% of direct labor costs.
Cost increases: In Years 2 and 3, management expects a 2% annual increase in direct material costs and a 3% increase in direct labor rates. (This increase is compounded so the increase in Year 3 costs is based off Year 2 cost figures).
Quality-related costs: The team estimates that Rentex's finished electric motor quality defects to be 2,500 ppm. Rentex's quality assurance department estimates that each defect costs the company $1,500 in nonconformance costs.
Preventive maintenance costs: Rentex's maintenance manager estimates that preventive maintenance of the production equipment required to produce the motors will cost $15,000 in Year 1, and will increase at the rate of 3% per year thereafter.
NOTES:
1. FOB (free on board) vessel means the supplier is responsible for transportation charges to the port in China.
2. Buyer is responsible for the cost and delivery of goods from the seller's location.
3. Transfer profit is the internal profit from selling to another unit in the company. This company views its units as profit centers, so profit must be included. Furthermore, the supplier has included profits in its quoted price.
Calculate the total cost per year for insourcing and outsourcing. Also calculate the cost per unit.
