Last year Precision Engineering purchased new machinery for £45000 for use in the manufacture of a part used in manufacturing the final product. The current level of output is 100000 items per year and the production will last another eight years. The direct manufacturing cost per unit is 50 pence and the raw material input costs another 40 pence per unit. Clyde Engineers, a competitive manufacturer of the above part, has developed new technology to manufacture the part and has offered to supply Precision Engineering at 83 pence per unit on a one-year renewable contract basis.
As a part of the contract, it has also offered to fulfill the entire requirement of Precision Engineering but each batch of supplies would consist of no less than 30000 items. Precision Engineering Purchasing Manager believes that the offer is very attractive. In the departmental meeting he argues that, with the cost of own manufacturing running at 95 pence per unit which, of course, includes the capital cost of the machine, the savings will total £96000 over 8 years. He, therefore, proposes that the indigenous manufacturing should be completely stopped, sell the machinery purchased only last year, and accept the Clyde Engineers offer. The Production Manager, who was responsible for the decision of buying and installing the machinery last year, has just come back after attending a Short Course on Project Appraisal in a prestigious Business School. He asserts that apart from problems of quality control and security of supplies, there is no economic case for purchasing the part from Clyde Engineers. To support his assertion he argues that machinery is virtually new and still has an economic life of eight years, and being of specialized nature has no alternative uses and could be sold only for £5000 in the market. With capital allowance at 25 percent on declining balance method on plant and machinery its current book value is £40000, and if sold in the market now would result in a loss of £35000. He claims that this initial loss of £35000 combined with an annual savings of £7000 over the next eight years will give a return on 'buy rather than make' of only 12 percent whereas the company's required rate of return is estimated at 20 percent. He reinforces his claim by pointing out that this was a highly conservative analysis since other serious problems have been ignored. The parts produced by the Clyde Engineers using new technology may vary in length by 4 mm, which may not cause a quality problem in the final product but would not only involve some redesign in the subassembly but also need supplementing the subassembly with another machine costing £8000. Even allowing for the tax allowances on the new machine, this in his view represents an unnecessary expenditure. The corporation tax rate currently is 25 percent. Furthermore, the supply of large batches of the part by Clyde Engineers would cause average stockholding of 15000 parts throughout the year as against the current stocks of two weeks supplies of materials and the finished part, and ten percent more of warehouse space would be occupied. The operator on the machine cannot be made redundant for another eight years as specified in his contract. The only alternative is to transfer him to another department at his current salary of £8000 per annum against the advertised post of an operator at £7000 per annum.
The Purchasing Manager considered the problem of the operator as a minor but perceived the increase in inventory as a real issue. The warehouse is only 60 percent utilized and an extension of the warehouse is planned only in another four years’ time. This would cost £50000 and the expected life of warehouse extension is estimated at 25 years for depreciation purposes. Since the use of this capacity would not involve any cash outlay, the Purchasing Manager maintains that cost of inventory could be ignored. He claims that he could be spending just £8000 and would be saving £96000 which is an excellent opportunity. Assume yourself as the Chairperson of the meeting, with your recently acquired knowledge of project appraisal as a part of your course; you will need to resolve the stalemate. Clearly, you will need to clarify the issues involved and arbiter which manager is correct and what decision is in the best interest of Precision Engineering.

Evaluate (critically) the arguments utilized by the Purchasing and the Production Managers to support their cases. Which is correct? (If either of two!)