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Santana Inc. manufactures widgets. The end product is produced in different departments within the plant. One component, C$1,$ is causing some concern. The component is integral to the production of widgets, but is readily available in the marketplace. The machine used to produce the component is nearing the end of its useful life and management is trying to decide whether to replace it or outsource the supply.

The current manufacturing costs of the C$1$ are as follows:

Direct materials $$20\mathrm{.}25$ per unit

Direct Labour $$16\mathrm{.}00$ per unit

Variable manufacturing overhead $$8\mathrm{.}00$ per unit

Variable general Administration $$7\mathrm{.}00$ per unit

Other costs related to C$1$ Department:

Supervision $$240,000$ per year

Amortization $$360,000$ per year

General Administration $$400,000$ per year

The plant can produce $100,000$ units per year. It needs $65,000$ units of C$1$ for widget production and sells $20,000$ units externally at a price of $$71\mathrm{.}00.$ It incurs variable selling costs of $$4\mathrm{.}00$ per unit when it sells C$1$ externally. Their policy is to fulfil internal requirements first, then sell C$1$ externally.

Pluto Corporation has approached Santana with a proposal to produce C$1$ for them. The cost would be $$69\mathrm{.}00$ per unit. Pluto guarantees on$-$time delivery and has agreed to a penalty of $25\%$ of revenue on any late shipments. Pluto has further agreed to provide up to $90,000$ units per year and has guaranteed the price of $$69\mathrm{.}00$ for the entire five year contract.

Santana can purchase a new machine to replace the existing equipment used to produce C$1$ for $$4,600,000.$ It is anticipated the new machine will result in labour cost savings of $10\%.$ All other costs will remain the same. The new machine$$s useful life is expected to be $5$ years and its residual value at that time will be $$150,000.$ It will be classified as a class $8$ asset for tax purposes, with a CCA of $18\%.$ The capacity of this new machine will be $100,000$ units per year. The corporate tax rate is $40\%$ and the company requires a $9\%$ return, after tax, on this investment.

Management of Santana asked its marketing research group to determine the anticipated demand for widgets over the next $5$ years. Management also asked the group to determine whether the excess capacity could be used to produce C$1$ for external sales.

The marketing group reported the following information:

$1.$ Demand for widgets will be approximately $65,000$ per year for the next three years, and will increase to $70,000$ in years $4$ and $5.$

$2.$ The company expects external sales will be $18,000$ units per year for the first three years and will increase to $25,000$ units per year for the last two years.

Management estimates that $40\%$ of the supervisory costs and $$100,000$ of general administration expenses would be eliminated if the C$1$ were outsourced.

Management also feels that there will need to be modifications to the design of the C$1$ in future years in order for the widget to remain competitive. The machine$$s manufacturer has assured Santana management that the changes will be possible at virtually no change in cost$.$ Pluto Corporation has indicated that any design changes would incur additional costs for Santana.

Required:

Assume that you have been hired by Santana Inc. to determine whether the company should buy the new machine or outsource production of C$1.$ Prepare a quantitative analysis, and evaluate any qualitative factors that will be relevant to the decision. Provide a recommendation for management.

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