TELOXY ENGINEERING (A)

Teloxy Engineering has received a one-time contract to design and build 10,000 units of a new product. During the proposal process, management felt that the new product could be designed and manufactured at a low cost. One of the ingredients necessary to build the product was a small component that could be purchased for $60 in the marketplace, including quantity discounts.

Accordingly, management budgeted $650,000 for the purchasing and handling of 10,000 components plus scrap.  During the design stage, your engineering team informs you that the final design will require a somewhat higher-grade component that sells for $72 with quantity discounts. The new price is substantially higher than you had budgeted for. This will create a cost overrun.

You meet with your manufacturing team to see if they can manufacture the component at a cheaper price than buying it from the outside. Your manufacturing team informs you that they can produce a maximum of 10,000 units, just enough to fulfill your contract. The setup cost will be $100,000 and the raw material cost is $40 per component. Since Teloxy has never manufactured this product before, manufacturing expects the following defects:

Percent defective 0 10 20 30 40

Probability of 10 20 30 25 15

occurrence

All defective parts must be removed and repaired at a cost of $120 per part.

1. Using expected value, is it economically better to make or buy the component?

2. Strategically thinking, why might management opt for other than the most economical choice?