Problem
The Shivon Company manufactures a product called Razar, a major component of which is called Razar. Currently, the company purchases 20,000 units per year of Razar from a supplier at a cost of $53 per unit. The company is considering manufacturing the Razar that it now purchases and has compiled the following data:
This process would require the purchase of a special machine costing $40,000. This machine would be used for four years, at which time it would be sold for $8,000, and it would be amortized using the straight-line method for financial accounting purposes.
Direct materials for the Razar would consist of 5 kilograms at a cost of $2.80 per kilogram.
Direct labour would be two hours per unit of Razar, with an average labour rate of $8 per hour (fringe benefit costs average 10 percent).
Supervision of the production of Razar would be handled by a manager who is currently paid $30,000 per year. He would continue with his present duties as well as supervising the production of Razar (expected to occupy 15 percent of his time) and would therefore be paid an additional $5,000 per year.
Variable overhead costs for the production of Razar are expected to total $3.50 per direct labour hour.
The main factory is rented for $80,000 per year for 5,000 square metres. The production of Razar should require an area of 500 square metres that is presently idle.
Other fixed overhead costs (all cash) would be applied at the rate of $6 per labour hour.
The manufacture of Razar would require an investment in working capital at the beginning of the project of $60,000.
The demand for Razar is expected to remain stable at 20,000 units per year during the four years.
Shivon's weighted average cost of capital is 12 percent, and the income tax rate is 35 percent.
Required
Use present value analysis to determine whether Shivon should continue to purchase the required Razar or manufacture them.