This is only question 2 in the chapter but I find many students find this harder than later questions. A very good concept question this is. I hope my answer is detailed enough.
The second bullet point is key. Think of opportunity cost, Do x and give up y. So bullet point 2 states if an outside supplier is used then Pentland Pumps can benefit with contribution of 75,000 (750 x (250-150)).
BUT we think of this 75,000 from a cost perspective (even though it is contribution) and would be added to option 1 (in-house manufacture) as IF option 1 is undertaken we would sacrifice this amount as it would only be earned IF option 2 (outside supplier) is undertaken which is stated in the second bullet. Again, this of opportunity cost. A term associated grately with Economics.
The marginal cost of making 3,500 pump motors per year (3,500 units at £85) £297,500 + contribution which will be lost from ‘olde worlds’ handpumps (750 units at £250 – £150) 75,000 = 372,500.
Buying in cost from outside supplier:
3,500 units at £95 = 332,500
Remember these two comparison values is COST so we are looking for the LOWEST to give the HIGHEST profit.
Therefore, by buying in pump motors from an outside supplier, the company has the potential to increase profits by £40,000 (£372,500 – £332,500).