For many years futura company has purchased the starters that it installs in its standard line of farm tractors. due to a reduction in output, the company has idle capacity that could be used to produce the starters. the chief engineer has recommended against this move, however, pointing out that the per unit cost to produce the 40,000 starters needed would be greater than the current $8.40 per unit purchase price:

By producing the starters the company will save $20,000 per year.

Explanation:

                        production costs

direct materials                                      $3.10 per unit

direct labor                                             $2.70 per unit

supervision                                            $60,000

depreciation                                          $40,000

variable manufacturing overhead        $0.60 per unit

rent                                                         $12,000

total production cost                             $9.20 per unit

The engineer is wrong because he is considering fixed costs like depreciation and rent that should not be included because they are independent on whether this project is approved or not. Once you take away depreciation and rent, the cost per unit will fall by $1.30 [= ($40,000 + $12,000) / 40,000 units].

Since the production cost = $9.20 - $1.30 = $7.90, which is lower than $8.40 which is the purchase cost, the company should start producing the starters at least until its sales bonce back.

By producing the starters the company will save ($8.40 - $7.90) x 40,000 units = $20,000 per year

reducing the scale of the market for a new product.

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