The Hyatt Company is trying to decide whether it should purchase new equipment so that it can continue to make its engines, a key component of its final product, internally or whether production should be discontinued and the engines purchased from an outside supplier.

New equipment for producing the engines can be purchased at a cost of $4,000,000. The equipment would have a five-year useful life (the company uses straight-line depreciation) and a $1,000,000 salvage value. Alternatively, the engines could be purchased from an outside suppler. The supplier has offered to provide the engines for $90 each under a five-year contract.

Hyatt Company’s present costs per unit of producing the engines internally (with the old equipment) are given below. The costs are based on a current activity level of 40,000 engines per year:

Direct materials ............................................................ $ 30.00
Direct labour (hourly employees) ................................. 42.00
Overhead ......................................................................... 43.00
Total cost per unit ....................................................... $115.00

The overhead amount of $43 per unit includes both variable and fixed items as follows:

Supplies (variable) ........................... $ 6.00
Supervision ......................................... 8.00
Depreciation ....................................... 9.00
General overhead ............................ 20.00

Supervision was directly traceable to the manufacturing activity and primarily involved supervising the hourly labour and overseeing production.

The new equipment would be more efficient and would reduce direct labour costs and variable overhead costs by 25%. Supervision cost ($320,000 per year) and direct materials cost per unit would not be affected by the new equipment. The company has no other use for the space now being used to produce the engines. The company’s total general overhead would not be affected by this decision.

Required:

1. Assume that 40,000 engines are needed each year. Should Hyatt purchase new equipment and continue manufacturing the engines, or should it buy the engines from the outside supplier? Provide all necessary calculations.

2. At what level of activity will the company be indifferent between the two options? Present all the necessary calculations.

3. The manager believes demand might drop in the future years and feels it is better to buy the engines rather than make them. Explain the rationale for such a decision.