4. (15 pts) Your manufacturing company is currently producing just enough of its
ID: 1167309 • Letter: 4
Question
4. (15 pts) Your manufacturing company is currently producing just enough of its best-selling wesomeGadgetX to meet this year's demand. The forecast for next year is in, and its demand is expected to double from 1 Million to 2 Million units/year and stay at this level for the next 3 years. To handle the new 1 Million units, your company can scrounge enough extra equipment and use current labor to handle most of the new parts and the final assembly. However, one part, SuperSickFeatureY (one needed in each unit), is at maximum production with your current equipment. Thus, you must either: i) acquire new equipment and new operators to make these critical parts yourself, or ii) contract with a 3rd party company, EvilSelloutCorporationZ, to buy the parts at a fixed rate over 3 years and have them delivered to your facility for final assembly. If your company's interest rate is 10%, determine how much it will cost per part to make them yourself, and then decide whether or not you should buy the parts from the 3rd party at $3.75 / part. Be sure to clearly show your work and your answer to the dilemma. Cost to Buy Parts from 3rd Party $3.75/ part Initial Capital Investment for Equipment Annual Operation & Maintenance for Equipment Annual Labor Cost for New Employees Raw Material Cost for Additional Parts Salvage Value at Year 3 of New Equipment $6,000,000 $1,000,000 $500,000 $0.30/part $1,000,000Explanation / Answer
The component requirement = 1 million per year, for next 3 years
Company has an option to make or buy this component.
Option A:
If it buys the component from 3rd party, each unit will cost $3.75. So, cost of every 1 million units = $3.75 million.
To compute total cost over next 3 years, we have to calculate the present value of entire cost over next 3 years, discounted at 10% interest rate.
Present value of the total cost = ($3.75 million / 1.1) + ($3.75 million / 1.1)2 + ($3.75 million / 1.1)3
= $(3.41 + 3.1 + 2.82) million = $9.33 million
Option B: Company decides to manufacture it.
Initial investment = $6 million
Annual operation plus labor cost = $1.5 million per year, for next 3 years
Raw material cost for 1 million units each year = $0.3 million per year, for next 3 years
Annual depreciation (Assuming straight line depreciation, with life 3 years) = ($6 million - $1 million) / 3 = $1.67 million per year
So, total annual cost = $(1.5 + 0.3 + 1.67) million = $5.27 million for next 3 years.
Present value of these annual costs = ($5.27 million / 1.1) + ($5.27 million / 1.1)2 + ($5.27 million / 1.1)3
=$(4.79 + 4.35 + 3.95) million = $13.09 million
Total cost = $(6 + 13.09) million = $19.09 million
To this, we can add the present value of the salvage value receivable at end of the 3rd year, but it is clear that even after adding that present value, the total cost of making in-house will be much higher than 3rd-party buying.
So the component should be purchased from 3rd party.
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