Orange, Inc., sells portable music players and other electronic products. The firm is contemplating introducing the fifth generation of its award winning player. The firm’s engineers have reduced the size of the product by a third, even as they have increased memory capacity and video resolution. The current dispute centers on a particular custom-designed component. This component was designed at a cost of about $750,000. The head of the design group observes that developing a supplier and so on for this new component will cost an additional $100,000. Moreover, the component costs $8 per piece. All of the required functionality could be delivered by slightly modifying an existing component, used in the current fourth-generation player, with a well-established supplier. Development costs for modifying the old component are likely to be around $18,000 and unit costs at $5 per piece. However, the older component would reduce battery life by 5% relative to the new component.

Currently, Orange projects selling between 1 and 2 million units of the product over its life cycle. The exact sales volume depends greatly on whether the product generates enough buzz to become a “must have” accessory for fashionable teens and young adults. The product’s average selling price is $249 per unit. Moreover, Orange usually has a 50% contribution margin ratio and a 20% profit margin on similar products.

Required:

a. For the decision of whether to launch the product with the new or old component, compute the incremental cost of using the custom-designed component over the new component.

b. What is your recommendation? Justify with appropriate supporting calculations.