An automobile company is considering an expansion project to produce gears that

Question

An automobile company is considering an expansion project to produce gears that the company has been buying for $300 each. If the company makes gears, it will incur materials cost of $ 90 per unit, labor costs of $120 per unit, and variable costs of $30 per unit. The annual fixed cost associated with the expansion is $ 240, 000 and the initial cost for the project is estimated $500, 000 and an additional cost of $50, 000 in year two. Demand for next 3 years is estimated at 4, 000 units/year (i = 7.8% compounded quarterly) a) Would it be profitable for the company to make the gears? b) Suppose the expansion could be used by another department for the production an agricultural equipment part that would cover its fixed and variable cost. If the an be bought for $350 and contribute extra $90, 000 from extra production savings, which would be more advantageous, gear production or agricultural equipment part production? Use breakeven analysis.

Explanation / Answer

a) For the automobile company if it buy gears the cost of buying is $300 each. The total demand for next 3 years will be 3*4000=12000 units.( As per year demand is estimated 4000 units).

Now the present total cost of buying all gears will be= $(12000*300)=$3600000.

As interest rate is associated with it we have to consider the overall future value of this total cost. Because the demand will be for the next 3 years and not now. To calculate the future the we consider the whole 1 year as 4 periods as interest rate is calculated quarterly. The formula for compound interest rate is total value is equal to P(1+r/n)nt, Here, P is the pricipal value, r is the rate of interest, n is the number of times compounded yearly, here it is 4, t is the total no of years. So total sum of value of $3600000 will be is equal to $3600000 (1+0.078/4)4*3 = $4538885.87.(see compound interest calculation).

Now if the automobile company produce the gears the total cost will be as follows

Per unit material cost=$90 + Per unit labour cost=$120 + Variable cost per unit= $30, So toatal unit cost will be= 90+120+30=$240/unit. The annual fixed cost is $240,000, For 3 years it will be 3*$240,000= $720,000. Initial Cost for the project is $500,000 and also an additional cost in year 2 is $50,000.

So the total cost will be =[ $240*12000units (total units cost) + $720,000(total fixed cost) + $500,000(initial cost) + $50,000(additional cost)]= $2880000+$720,000+$500,000+$50,000= $4150000.

If we consider this the profitable condition will be to make the gear for the automobile comapany. Now if we cosider the rate of int for initial cost and fixed cost the sccenario will be as follows:

Now the effective cost after considering the interest rate will be different. The future value for initial cost will be = $630,400.81( by using compound interest formula) and the effective fixed cost will be = $302,592.39(for 1st year F.C)+ $280,097.40(for 2nd yr FC)+ $259,274.71(for 3rd year)= total effective fixed cost $841964.5. The effective additional cost for year 2 will be= $54,017.57.

So the total effective cost will be = $288,0000 + $841,964.50 + $630,400.81 + $54,017.57= $ 4406382.88

So comparing both the cost(bold value) we can conclude that it would be profitable for automobile company to make it..

b) In case of breakeven analysis it comes to no profit no loss situation. but for this answer it requires more clear information. It is not clear to me.

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