Finance

Dear Mr. Abbott,

As the company is facing with the decision whether to build a part in-house or outsource the production to outside supplier, I have calculated some information that you requested. To come up with these calculations, I have made the following assumptions along with the information you provided.

First, the amount of $500,000 HP has spent designing and testing the part would be the sunk cost. This cost was already incurred and it could not be changed no matter what. The second issue we should be concerned about is the opportunity cost of 20,000 square-feet of HP’s primary production facility. Even though the space is currently unused and there are no plans to make use of it in the near future, at a minimum, we still can sell it for some value. The value we have to give up to undertake the project would be our opportunity cost and it should be included in the analysis. However, in this case, we assume that the opportunity cost of the 20,000 square-feet of primary production facility is zero since we do not know of any information about its market value. We also assume that the training, retooling and equipment purchases incur in year 0. Since the production expenses, which include labor costs and material cost, start in year 1, I assume the working capital also starts in year 1. The cost of production manager and labor force starting in year 1 would be $70,000 and $1,000,000 respectively because we only take into account the effect of incremental costs. The discount rate is assumed to be calculated correctly with the tax rate of 35%. Finally, we assume the quality of the products produced by the company or the supplier are the same. Therefore, the revenue generated is also the same.

Based on these assumptions, the present value of the total cost of producing the part in- house would be $10,088,422.82, and the present value of the cost of contracting with the supplier under the $1/unit contract would be $9,305,544.77 (Exhibit 1). This means HP...