Chapter 17, Problem 31P

Morrill Company produces two different types of gauges: a density gauge and a thickness gauge. The segmented income statement for a typical quarter follows.

*Includes depreciation.

The density gauge uses a subassembly that is purchased from an external supplier for $25 per unit. Each quarter, 2,000 subassemblies are purchased. All units produced are sold, and there are no ending inventories of subassemblies. Morrill is considering making the subassembly rather than buying it. Unit-level variable manufacturing costs are as follows:

No significant non-unit-level costs are incurred.

Morrill is considering two alternatives to supply the productive capacity for the subassembly.

1. 1. Lease the needed space and equipment at a cost of $27,000 per quarter for the space and $10,000 per quarter for a supervisor. There are no other fixed expenses.
2. 2. Drop the thickness gauge. The equipment could be adapted with virtually no cost and the existing space utilized to produce the subassembly. The direct fixed expenses, including supervision, would be $38,000, $8,000 of which is depreciation on equipment. If the thickness gauge is dropped, sales of the density gauge will not be affected.

Required:

1. 1. Should Morrill Company make or buy the subassembly? If it makes the subassembly, which alternative should be chosen? Explain and provide supporting computations.
2. 2. Suppose that dropping the thickness gauge will decrease sales of the density gauge by 10 percent. What effect does this have on the decision?
3. 3. Assume that dropping the thickness gauge decreases sales of the density gauge by 10 percent and that 2,800 subassemblies are required per quarter. As before, assume that there are no ending inventories of subassemblies and that all units produced are sold. Assume also that the per-unit sales price and variable costs are the same as in Requirement 1. Include the leasing alternative in your consideration. Now, what is the correct decision?

To determine

Describe whether company M should make or buy the subassembly. Assume that the company has to choose the making decision, state the alternative that should be chosen and provide the supporting calculations.

Explanation of Solution

Tactical decision making: Tactical decision making is a process in which the company can choose the correct alternative based on the profitability. In tactical decision making, offer price of a product is compared with the normal selling price and offer price less than the normal selling price of product is considered as the idle capacity for decision making.

Indicate whether company M should make or buy the subassembly:

Particulars	Lease and make	Buy
Purchase cost (1)	$0	$50,000
Variable manufacturing cost (2)	$14,000	$0
Lease expense	$27,000	$0
Supervisor salary	$10,000	$0
Total relevant cost	$51,000	$51,000

Table (1)

If company has chosen the make decision, which alternative should be chosen:

Particulars	Drop thickness gauge and make
Purchase cost (1)	$0
Variable manufacturing cost (2)	$14,000
Lost contribution margin	$34,000
Total relevant cost	$48,000

Table (2)

Note: The direct fixed expense is same for all alternatives.

In this case, the company should choose the making decision because the subassembly would produce more income than the thickness gauge.

Working note (1):

Calculate the purchase cost of subassembly.

$\begin{array}{c}\text{Purchase cost = }\left(\begin{array}{l}\text{Number of subassemblies per quarter }\times \\ \text{Cost per subassembly}\end{array}\right)\\ =2,000\times \$25\\ =\$50,000\end{array}$

Working note (2):

Calculate the variable manufacturing cost.

$\begin{array}{c}\begin{array}{l}\text{Variable }\\ \text{manufacturing cost}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Number of subassembly ×}\\ \left[\begin{array}{l}\text{Direct material per unit+}\\ \text{Direct labor per unit}\\ \text{Variable overhead per unit}\end{array}\right]\end{array}\right)\\ \text{=2,000×}\left(\text{\$2+\$3+\$2}\right)\\ \text{=\$14,000}\end{array}$

To determine

State the effect of the given decision; assume that dropping the thickness gauge decreases the sale of density gauge by 10%.

Explanation of Solution

State the effect of the decision if dropping in thickness gauge will decreases the sale of density gauge by 10% as follows:

Particulars	Make	Buy
Lost sales for density gauge (3)	$15,000	$0
Cost of making component (4)	$12,600	$0
Less: Reduction of other variable costs (5)	($3,000)	$0
Purchase cost (1)	$34,000	$50,000
Total relevant cost	$58,600	$50,000

Table (3)

If company is choose buy alternative, then the sales volume is not reduced and the same number of components would be needed for the production process.

Working note (3):

Calculate the lost sales for density gauge.

$\begin{array}{c}\text{Lost sale of density gauge = Total sales }\times \text{10\%}\\ =\$150,000\times 10\%\\ =\$15,000\end{array}$

Working note (4):

Calculate the cost of making component.

$\begin{array}{c}\begin{array}{l}\text{Cost of making }\\ \text{component}\end{array}\}\text{ =}\left[\begin{array}{l}\left(\begin{array}{l}\text{Number of subassembly ×}\\ \left[\begin{array}{l}\text{Direct material per unit+}\\ \text{Direct labor per unit}\\ \text{Variable overhead per unit}\end{array}\right]\end{array}\right)\times \\ \left(\begin{array}{l}100\%-\\ \text{Percetage of dropped sale}\end{array}\right)\end{array}\right]\\ \text{=}\left[\text{2,000×}\left(\text{\$2+\$3+\$2}\right)\right]\times \left(100\%-10\%\right)\\ \text{=\$12,600}\end{array}$

Working note (5):

Calculate the other variable cost.

$\begin{array}{c}\begin{array}{l}\text{Cost of other }\\ \text{vairable cost}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Varaible expense }-\\ \text{Purchase cost (1)}\end{array}\right)\times 10\%\\ =\left(\$80,000-\$50,000\right)\times 10\%\\ =\$3,000\end{array}$

To determine

Indicate the correct decision for the given situation.

Explanation of Solution

Indicate the correct decision for the given situation as follows:

Particulars	Lease and make	Buy
Purchase cost (6)	$0	$70,000
Variable manufacturing cost (7)	$19,600	$0
Lease expense	$27,000	$0
Supervisor salary	$10,000	$0
Total relevant cost	$56,600	$70,000

Table (4)

If the dropping the thickness gauge decreases the sales of density gauge by 10%:

Particulars	Drop thickness gauge and make
Purchase cost	$0
Lost sales from density gauge (3)	$15,000
Variable manufacturing cost (8)	$17,640
Less: Other variable cost (9)	($1,000)
Lost contribution margin	$34,000
Total relevant cost	$65,640

Table (5)

Note: The direct fixed expense is same for all alternatives.

In this case, the company should make the component because the total relevant cost of making decision ($56,600) is less than the buying decision ($70,000) and dropping the thickness gauges ($65,640).

Working note (6):

Calculate the purchase cost of subassembly.

$\begin{array}{c}\text{Purchase cost = }\left(\begin{array}{l}\text{Number of subassemblies per quarter }\times \\ \text{Cost per subassembly}\end{array}\right)\\ =2,800\times \$25\\ =\$70,000\end{array}$

Working note (7):

Calculate the variable manufacturing cost.

$\begin{array}{c}\begin{array}{l}\text{Variable }\\ \text{manufacturing cost}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Number of subassembly ×}\\ \left[\begin{array}{l}\text{Direct material per unit+}\\ \text{Direct labor per unit}\\ \text{Variable overhead per unit}\end{array}\right]\end{array}\right)\\ \text{=2,800×}\left(\text{\$2+\$3+\$2}\right)\\ \text{=\$19,600}\end{array}$

Working note (8):

Calculate the cost of making component.

$\begin{array}{c}\begin{array}{l}\text{Cost of making }\\ \text{component}\end{array}\}\text{ =}\left[\begin{array}{l}\left(\begin{array}{l}\text{Number of subassembly ×}\\ \left[\begin{array}{l}\text{Direct material per unit+}\\ \text{Direct labor per unit}\\ \text{Variable overhead per unit}\end{array}\right]\end{array}\right)\times \\ \left(\begin{array}{l}100\%-\\ \text{Percetage of dropped sale}\end{array}\right)\end{array}\right]\\ \text{=}\left[\text{2,600×}\left(\text{\$2+\$3+\$2}\right)\right]\times \left(100\%-10\%\right)\\ \text{=\$17,640}\end{array}$

Working note (9):

Calculate the other variable cost.

$\begin{array}{c}\begin{array}{l}\text{Cost of other }\\ \text{vairable cost}\end{array}\}\text{ = }\left(\begin{array}{l}\text{Varaible expense }-\\ \text{Purchase cost (1)}\end{array}\right)\times 10\%\\ =\left(\$80,000-\$70,000\right)\times 10\%\\ =\$1,000\end{array}$