MA – L2 – Q44 – Relevant cost and revenue

Recommend whether TechLink Solutions should buy new equipment or outsource electronic modules for 400,000 units annually.

Question

TechLink Solutions Limited manufactures and sells routers. It manufactures its own electronic modules (EM), an important part of the router. The present cost to manufacture an EM is as follows:

	GH¢
Direct material	250
Direct labour	300
Variable overheads	150
Fixed overheads
Depreciation	100
General overheads	150
Total cost per unit	950

The company manufactures 400,000 units annually. The equipment being used for manufacturing EM has worn out completely and requires replacement. The company is presently considering the following options:
(A) Purchase new equipment which would cost GH¢ 240 million and have a useful life of six years with no salvage value. The company uses straight-line method of depreciation. The new equipment has the capacity to produce 600,000 units per year. It is expected that the use of new equipment would reduce the direct labour and variable overhead cost by 20%.
(B) Purchase from an external supplier at GH¢ 730 per unit under a two-year contract.
The total general overheads would remain the same in either case. The company has no other use for the space being used to manufacture the EMs.

Required:
(a) Which course of action would you recommend to the company assuming that 400,000 units are needed each year? (Show all relevant calculations)

(b) What would be your recommendation if the company’s annual requirements were 600,000 units?

Answer

To recommend the best course of action for TechLink Solutions Limited, we need to compare the relevant costs of producing 400,000 electronic modules (EM) annually by purchasing new equipment (Option A) versus purchasing from an external supplier (Option B).

Option A: Purchase New Equipment

Initial Investment: GH¢ 240 million for new equipment with a 6-year life and no salvage value.
Depreciation: Straight-line method = GH¢ 240,000,000 ÷ 6 years = GH¢ 40,000,000 per year. Depreciation is a non-cash expense but relevant for cost allocation.
Annual Production: 400,000 units.
Cost Savings: New equipment reduces direct labour and variable overhead costs by 20%.

Current Costs per Unit (as given):

Cost Component	GH¢ per Unit
Direct Material	250
Direct Labour	300
Variable Overheads	150
Depreciation	100
General Overheads	150
Total	950

Adjusted Costs with New Equipment:

Direct Material: Remains unchanged at GH¢ 250 per unit.
Direct Labour: Reduced by 20% = GH¢ 300 × (1 – 0.20) = GH¢ 240 per unit.
Variable Overheads: Reduced by 20% = GH¢ 150 × (1 – 0.20) = GH¢ 120 per unit.
Depreciation: New equipment depreciation = GH¢ 40,000,000 ÷ 400,000 units = GH¢ 100 per unit.
General Overheads: Remain unchanged at GH¢ 150 per unit (as stated, total general overheads remain the same).

New Cost per Unit:

Cost Component	GH¢ per Unit
Direct Material	250
Direct Labour	240
Variable Overheads	120
Depreciation	100
General Overheads	150
Total	860

Total Annual Cost for 400,000 Units:

GH¢ 860 × 400,000 = GH¢ 344,000,000.

Relevant Costs:

Exclude sunk costs and non-incremental costs. General overheads are irrelevant as they remain the same in both options.
Relevant costs per unit = Direct Material (GH¢ 250) + Direct Labour (GH¢ 240) + Variable Overheads (GH¢ 120) = GH¢ 610.
Total relevant cost = GH¢ 610 × 400,000 = GH¢ 244,000,000.
Add incremental fixed cost (depreciation) = GH¢ 40,000,000.
Total relevant cost = GH¢ 244,000,000 + GH¢ 40,000,000 = GH¢ 284,000,000.

Option B: Purchase from External Supplier

Purchase Price: GH¢ 730 per unit.
Annual Production: 400,000 units.
Total Cost: GH¢ 730 × 400,000 = GH¢ 292,000,000.
Relevant Costs: The purchase price is the only relevant cost since general overheads remain the same, and no additional fixed costs are incurred.
Total relevant cost = GH¢ 292,000,000.

Comparison:

Option	Total Relevant Cost (GH¢)
Option A (New Equipment)	284,000,000
Option B (External Supplier)	292,000,000

Savings with Option A:

GH¢ 292,000,000 – GH¢ 284,000,000 = GH¢ 8,000,000 per year.

Recommendation: Option A (purchasing new equipment) is recommended as it results in a lower total relevant cost of GH¢ 284,000,000 compared to GH¢ 292,000,000 for Option B, saving GH¢ 8,000,000 annually when producing 400,000 units.

(B) To recommend the best course of action for TechLink Solutions Limited when the annual requirement is 600,000 electronic modules (EM), we compare the relevant costs of producing 600,000 units by purchasing new equipment (Option A) versus purchasing from an external supplier (Option B).