Lindon Company uses 5,000 units of Part X each year as a component in the assembly of one of its products. The company is presently producing Part X internally at a total cost of $80,000 as follows: Direct Materials$18,000 Direct Labor20,000 Variable Manufacturing Overhead 12,000 Fixed Manufacturing Overhead 30,000 Total Costs$80,000 An outside supplier has offered to provide Part X at a price of $13 per unit. If Lindon Company stops producing the part internally, one-third of the fixed manufacturing overhead would be eliminated. INSTRUCTIONS Prepare an analysis showing the annual advantage or disadvantage of accepting the outside supplier's offer. When complete, answer each of the following by selecting the correct match from the list provided. - What is the total outside purchase price for 5,000 units

Check the explanation

Explanation:

Part a-1

Calculate the accounting break-even point

At break-even point the net income is zero

Quantity Q = 80,000

Price per unit P = $38

Unit Variable cost VC = $24

Fixed costs FC = $680,000

Tax rate t = 22%

Net income NI = (Q * (P -  VC) - FC)) * (1 - t)

Q = (NI / (1 - t) + FC) / (P -  VC)

= FC / (P -  VC)

= $680,000 / ($38 - $24)

= 48571.43

Accounting break-even = Q * P

= 48571.43 * $38

= $1,845,714.29

The accounting break-even point is $1,845,714.29

Part a-2

Calculate the degree of operating Leverage at accounting break-even level

Fixed costs = $680,000

Asset Investment = $560,400

Project life = 6 years

Depreciation = Asset Investment / Project life

= $560,400 / 6

= $93,400

At accounting breakeven level the operating cash flow is equal to depreciation

Operating cash flow = Depreciation

= $93,400

Degree of operating Leverage = 1 + Fixed costs / operating cash flow

= 1 + $680,000 / $93,400

= 8.2805

The degree of operating Leverage at accounting break-even level is 8.2805

Part b-1

Calculate the base case Cash flow and NPV

Asset Investment = $560,400

Quantity Q = 80,000

Price per unit P = $38

Unit Variable cost VC = $24

Fixed costs FC = $680,000

Tax rate t = 22%

Required return r = 10%

Project life n = 6 years

Depreciation D = $93,400

PVIFA(r,n) = (1 - (1 + r)^-n)/r

Cash flow = (Q * P - (Q * VC + FC)) * (1 - t) + D * t

= (80,000 * $38 - (80,000 * $24 + $680,000)) * (1 - 22%) + $93,400 * 22%

= $363,748.00

The base case Cash flow is $363,748.00

NPV = Cash flow * PVIFA(10%,6) - Asset Investment

= $363,748.00 * (1 - (1 + 10%)^-6)/10% - $560,400

= $1,023,817.37

The base case NPV is $1,023,817.37

Part b-2

Calculate the sensitivity of NPV to changes in quantity sold

Assume a 10% quantity increase

Base case Quantity Q0 = 80,000

New case Quantity Q1 = Q0 * (1 + 10%)

= 80,000 * (1 + 10%)

= 88,000

Cash flow CF1 = (Q * P - (Q * VC + FC)) * (1 - t) + D * t

= (88,000 * $38 - (88,000 * $24 + $680,000)) * (1 - 22%) + $93,400 * 22%

= $451,108

Base case NPV = $1,023,817.37

NPV1 = CF1 * PVIFA(10%,6) - Asset Investment

= $451,108 * (1 - (1 + 10%)^-6)/10% - $560,400

= $1,404,292.94

∆Q = Q1 - Q0

= 88,000 - 80,000

= 8,000

∆NPV = NPV1 - Base case NPV

= $1,404,292.94 - $1,023,817.37

= $380,475.57

Sensitivity = ∆NPV / ∆Q

= $380,475.57 / 8,000

= $47.56

The sensitivity of NPV to changes in quantity sold is $47.56

Part c

Calculate the sensitivity of OCF to change in variable cost

Assume the variable cost increase by 10%

Base case variable cost VC0 = $24

New case Variable cost VC1 = VC0 * (1 + 10%)

= $24 * (1 + 10%)

= $26.40

Base case cash flow OCF0 = $363,748.00

New case cash flow OCF1 = (Q * P - (Q * VC1 + FC)) * (1 - t) + D * t

= (80,000 * $38 - (80,000 * $26.40 + $680,000)) * (1 - 22%) + $93,400 * 22%

= $213,988.00

∆OCF = OCF1 - OCF0

= $213,988.00 - $363,748.00

= -$149,760.00

∆VC = VC1 - VC0

= $26.40 - $24

= $2.40

Sensitivity = ∆OCF / ∆VC

= -$149,760.00 / $2.40

= -$62,400

The sensitivity of OCF to change in variable cost -$62,400