Waterways has discovered that a small fitting it now manufactures at a cost of $1.00 per unit could be bought elsewhere for $0.83 per unit. Waterways has fixed costs of $0.20 per unit that cannot be eliminated by buying this unit. Waterways needs 474,000 of these units each year. If Waterways decides to buy rather than produce the small fitting, it can devote the machinery and labor to making a timing unit it now buys from another company. Waterways uses approximately 500 of these units each year. The cost of the unit is $13.26. To aid in the production of this unit, Waterways would need to purchase a new machine at a cost of $2,369, and the cost of producing the units would be $10.00 a unit. What is Waterways’ opportunity cost if it chooses to buy the small fitting and start manufacturing the timing unit?
The opportunity cost for Waterways if it chooses to buy the small fitting and start manufacturing the timing unit can be calculated as follows:
Cost of buying small fitting elsewhere: $0.83 per unit
Cost of producing small fitting in-house: $1.00 per unit
Savings per unit by buying: $1.00 - $0.83 = $0.17
Potential savings per year by buying the small fitting instead of producing in-house:
$0.17 * 474,000 units = $80,580
Cost of producing timing unit in-house: $10.00 per unit
Current cost of buying timing unit: $13.26 per unit
Savings per unit by producing in-house: $13.26 - $10.00 = $3.26
Potential savings per year by producing timing unit in-house:
$3.26 * 500 units = $1,630
Cost of new machine: $2,369
Therefore, the opportunity cost for Waterways if it chooses to buy the small fitting and start manufacturing the timing unit is:
$80,580 + $1,630 + $2,369 = $84,579.