Sergo Games produces a variety of action games including a flight simulation game, Airport 10, which sold more than 800,000 copies in the past year. The programs are run on computers, and the company operates an in-house production facility that manufactures and packages CDs for shipment to customers. In 2011, the production plant prepared 3,000,000 CDs and incurred the following costs:
Units processed 3,000,000
Labor $1,000,000
Material 5,400,000
Supervisory salaries 300,000
Depreciation of equipment 400,000
Heat, light, phone, etc. 200,000
Total $7,300,000
1 of 2 8/25/2010 11:05 PMLeslie Eastman, an accounting manager, has been given the responsibility to analyze outsourcing the production of CDs. Her
report is provided below.
Required
Should production of CDs be outsourced? Unlike Leslie, support your answer with appropriate calculations.
Sergo Games
April 19, 2012
TO: Shane Santiago, CFO
FROM: Leslie Eastman
SUBJECT: Outsourcing CD production
In 2011, total production and packaging costs were $7,300,000 or $2.43 per CD. The low-cost outside bidder for this  business was XLS. They are a highly respected firm, and their offer is $2.33 per CD. Although the savings related to outsourcing is only $0.10 per CD, with annual production of 3,000,000 units, this amounts to $300,000 per year. The present value with a five-year horizon and a 12 percent cost of capital is $1,081,440. Thus, I recommend that we outsource CD production. You asked me to determine the selling price of the production equipment. I had a representative of XLS walk through the facility. In his opinion, the equipment is dated, and he believes that the market value is essentially zero. At any rate, his company is not interested in purchasing the equipment even if we select them as a supplier. If we outsource, I do not believe that we can use the production facility for another purpose. As you know, the building is run down, and it's not a
suitable space even for programmers! Finally, I want to mention another aspect of the problem that enhances the appeal of outsourcing. We currently have equipment with a book value of $2,000,000 and an average remaining life of five years. This generates approximately $400,000 per year of depreciation. If we outsource, we'll have a $2,000,000 tax loss, which will save us approximately $700,000 (assuming a 35 percent tax rate). Thus, the total value of outsourcing is $1,781,440 (i.e., $1,081,440 + $700,000). Please call me if you have any questions regarding my analysis.