91Ó°ÊÓ

(A. Atkinson, adapted) Denver Engineering manufactures small engines that it sells to manufacturers who install them in products such as lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier who wishes to supply the starter assemblies used in these engines. The starter assemblies are currently manufactured in Division 3 of Denver Engineering. The costs relating to the starter assemblies for the past 12 months were as follows: Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each starter assembly is \(\$ 10(\$ 1,500,000 \div 150,000)\). Further analysis of manufacturing overhead revealed the following information. \(0 f\) the total manufacturing overhead, only \(25 \%\) is considered variable. \(0 f\) the fixed portion, \(\$ 300,000\) is an allocation of general overhead that will remain unchanged for the company as a whole if production of the starter assemblies is discontinued. A further \(\$ 200,000\) of the fixed overhead is avoidable if production of the starter assemblies is discontinued. The balance of the current fixed overhead, \(\$ 100,000,\) is the division manager's salary. If Denver Engineering discontinues production of the starter assemblies, the manager of Division 3 will be transferred to Division 2 at the same salary. This move will allow the company to save the \(\$ 80,000\) salary that would otherwise be paid to attract an outsider to this position. 1\. Tutwiler Electronics, a reliable supplier, has offered to supply starter- assembly units at \(\$ 8\) per unit. Because this price is less than the current average cost of \(\$ 10\) per unit, the vice president of manufacturing is eager to accept this offer. 0 n the basis of financial considerations alone, should Denver Engineering accept the outside offer? Show your calculations. (Hint: Production output in the coming year may be different from production output in the past year.) 2\. How, if at all, would your response to requirement 1 change if the company could use the vacated plant space for storage and, in so doing, avoid \(\$ 100,000\) of outside storage charges currently incurred? Why is this information relevant or irrelevant?

Step by step solution

01

Variable Overhead Calculation

\(Variable\ Overhead = 1,500,000 \times 0.25 = 375,000\) Next, we calculate the cost per starter assembly for materials, labor, and variable overhead:

02

Cost per unit Calculation

\(Cost\ per\ unit = \frac{375,000}{150,000} = \$ 2.50\) Now let's calculate the avoidable fixed costs. We know that \(200,000 of the fixed overhead is avoidable if production is discontinued. We also know that the manager's salary (\)100,000) can avoid \(\$80,000\) of salary if he is transferred to Division 2.

03

Avoidable Fixed Costs Calculation

\(Avoidable\ Fixed\ Costs = 200,000 + 80,000 = 280,000\) Finally, we calculate our total costs when manufacturing the starter assemblies:

04

Total Manufacturing Costs Calculation

\(Total\ Manufacturing\ Costs = 375,000 + 280,000 = \$ 655,000\) Now let's compare the costs of outsourcing the starter assemblies:

05

Outsourcing Cost Calculation

\(Outsourcing\ Cost = 150,000 \times 8 = \$ 1,200,000\) Comparing both costs, we find that it is financially advantageous to accept the offer from Tutwiler Electronics. #2. Evaluate the impact of using the vacated plant space# Now we need to check if the company can save $100,000 on outside storage charges by using vacated plant space. This information is relevant as it would help offset the outsourcing cost.

06

Adjusted Outsourcing Cost Calculation

\(Adjusted\ Outsourcing\ Cost = 1,200,000 - 100,000 = \$ 1,100,000\) Comparing the adjusted outsourcing cost with the total manufacturing cost:

07

Comparison

Manufacturing: \$ 655,000, Outsourcing: \$ 1,100,000 It is still financially advantageous to accept the offer from Tutwiler Electronics even with the additional storage savings.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Variable Costs

Variable costs play a critical role in determining the cost-effectiveness of manufacturing decisions. In the context of Denver Engineering, variable costs are the expenses that change in proportion to the production volume. For example, if Denver manufactures more engines, the costs for materials and labor will increase accordingly.

• Variable overhead is the portion of overhead costs that varies with production activity.
• In the original problem, 25% of the manufacturing overhead, or $375,000, is identified as variable based on the total manufacturing cost of $1,500,000.
• This means that for each starter assembly produced, $2.50 accounts for the variable cost.

Understanding variable costs is crucial because it helps in evaluating the cost-effectiveness of continuing production versus outsourcing, by comparing costs directly tied to production.

Fixed Costs

Fixed costs are the expenses that remain constant regardless of the company's level of production or sales. In Denver Engineering's case, these are costs such as salary of the division manager and certain general overheads that don't change with the production volume.

• In this scenario, fixed overhead includes unavoidable general overhead of $300,000 and the division manager's salary of $100,000.
• If production stops, $200,000 of fixed overhead is avoidable, reducing the burden.
• The manager’s salary being transferred saves the company an additional $80,000.

It's important for businesses to track fixed costs diligently, as they can significantly affect profit margins when production levels fluctuate.

Outsourcing Decision

An outsourcing decision involves evaluating the benefits of obtaining goods or services from an external supplier against the costs of producing them in-house. For Denver Engineering, this involves considering purchasing starter assemblies from Tutwiler Electronics.

• The cost of producing in-house is calculated as $655,000, combining variable costs and avoidable fixed costs.
• The outsourcing option initially costs $1,200,000, which, after considering storage savings, is adjusted to $1,100,000.
• Despite initial appearances, when fixed and variable costs are accounted for, producing in-house remains more economically sound than outsourcing in this scenario.

Decisions like these require careful analysis to ensure that the company maintains cost efficiency while balancing quality and reliability.

Avoidable Costs

Avoidable costs are expenses that can be eliminated if a certain operation or procedure is stopped. For Denver Engineering, these are the costs that can be saved by discontinuing production of starter assemblies.

• The problem outlines $200,000 of fixed overhead as avoidable should production cease.
• An additional $80,000 from the division manager’s salary becomes avoidable by reallocating the manager.
• In total, $280,000 can be saved if the company chooses to outsource.

Recognizing avoidable costs helps the company in deciding if stopping a particular operation can benefit them financially in the long run. This is a vital consideration when contemplating moves like outsourcing or reducing production.