Problem - The Baker Company's old equipment for making motors is worn out. The company is considering two courses of action: (1) completely replacing the old equipment with new equipment or (2) buying the motors from an outside supplier, who has quoted a unit purchase price of $90 on a seven year contract for a minimum of 50,000 motors per year.
Production was 60,000 motors in each of the past two years. Future needs for the next seven years are not expected to fluctuate beyond 50,000 to 70,000 motors per year. Cost records for the past two years reveal the following unit costs of manufacturing each motor:
Direct Materials $30
Direct Labor 35
Variable Overhead 10
Fixed Overhead (including $10 depreciation, $10 for direct departmental overhead, and $5 for allocated fixed overhead) 25
Total $100
The new equipment will cost $18,800,000, will last seven years, and will have zero disposal value. The current disposal value of the old equipment is $3,000,000.
The sales representative for the new equipment has summarized her position as follows: The increase in machine speeds will reduce direct labor costs by $30 per motor and variable overhead costs by $5 per motor. Consider last year's experience of one of your major competitors with identical equipment.
They produced 100,000 motors under operating conditions very comparable to yours and showed the following unit costs:
Direct Materials $30
Direct Labor 5
Variable Overhead 5
Fixed Overhead (including depreciation of $24 per motor) 40
Total - $80
For purposes of this problem, assume that any idle facilities and equipment cannot be put to any alternative use. Also, assume that Baker's allocated fixed overhead costs will not be affected by the company's decision. Ignore all tax implications.
A. The president of Baker Company has asked you to compare alternatives under the assumption that 60,000 motors per year will be needed over the next seven years.
1. Calculate the impact on Baker's cash flow over the next seven years if the company chooses the first alternative, replace the old equipment and continue to manufacture motors.
2. Calculate the impact on Baker's cash flow over the next seven years if the company chooses the second alternative, buy the motors from the outside supplier and dispose of the old equipment.
3. Based upon your previous calculations, which alternative seems more attractive?
B. At what volume level (annual number of motors) would Baker be indifferent between the two alternatives, (1) purchasing the new equipment and continuing to make the motors versus (2) disposing of the old equipment and buying the motors from the outside supplier?
C. List at least three qualitative (non quantitative) factors that Baker should consider when making this decision.