Morrill Company produces two different types of gauges: a density gauge and a thickness gauge. The segmented income statement for a typical quarter follows.
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:
Direct materials … $2
Direct labor …… 3
Variable overhead … 2
No significant non-unit-level costs are incurred. Morrill is considering two alternatives to supply the productive capacity for the subassembly.
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. 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.
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. 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. 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?