Question

“In my opinion, we ought to stop making our own drums and accept that outside supplier’s offer,” said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. “At a price of $20 per drum, we would be paying $4.25 less than it costs us to manufacture the drums in our own plant. Since we use 75,000 drums a year, that would be an annual cost savings of $318,750.” Antilles Refining’s current cost to manufacture one drum is given below (based on 75,000 drums per year): Direct materials $ 11.10 Direct labor 6.00 Variable overhead 1.60 Fixed overhead ($2.80 general company overhead, $1.75 depreciation, and, $1.00 supervision) 5.55 Total cost per drum $ 24.25 A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are: Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $225,000 per year. Alternative 2: Purchase the drums from an outside supplier at $20 per drum. The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 25%. The old equipment has no resale value. Supervision cost ($75,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 125,000 drums per year. The company’s total general company overhead would be unaffected by this decision. (Round all intermediate calculations to 2 decimal places.) Required: 1. To assist the managing director in making a decision, prepare an analysis showing the total cost and the cost per drum for each of the two alternatives given above. Assume that 75,000 drums are needed each year. a. What will be the total relevant cost of 75,000 drums if they are manufactured internally as compared to being purchased? b. What would be the per unit cost of each drum manufactured internally? (Round your answer to 2 decimal places.) c. Which course of action would you recommend to the managing director? Purchase from the outside supplier Manufacture internally Indifferent between the two alternatives 2a-1. What will be the total relevant cost of 93,750 drums if they are manufactured internally? 2a-2. What would be the per unit cost of drums? 2 a-3. What course of action would you recommend if 93,750 drums are needed each year? Indifferent between the two alternatives Manufacture internally Purchase from the outside supplier 2b-1. What will be the total relevant cost of 125,000 drums if they are manufactured internally? 2b-2. What would be the per unit cost of drums? (Round your answer to 2 decimal places.) 2b-3. What course of action would you recommend if 125,000 drums are needed each year? Manufacture internally Purchase from the outside supplier Indifferent between the two alternatives

Answer 1

Ques 1
The $2.80 per drum general overhead cost is not relevant to the decision because this cost will be the same regardless of whether the company decides to make or buy the drums. Also, the present depreciation figure of $1.75 per drum is not a relevant cost because it represents a sunk cost (in addition to the fact that the old equipment is worn out and must be replaced). The cost of supervision is relevant to the decision because this cost can be avoided by buying the drums
										Differential costs per drum			Total Differential costs -75000
	Make	Buy		Make	Buy
Outside suppliers price		$     20.00			$        1,500,000
Direct materials	$     11.10			$            832,500
Direc Labor	$       4.50			$            337,500
($6*75%)
Variable overhead	$       1.20			$              90,000
($1.60*75%)
Supervision	$       1.00			$              75,000
Equipment rental	$       3.00			$            225,000
($225000/75000 drums)
Total cost	$     20.80	$     20.00		$        1,560,000	$        1,500,000
financial advantage from buying	$                             0.80			$                                               60,000
Ques 2:
	Differential costs per drum			Total Differential costs -93750
	Make	Buy		Make	Buy
Outside suppliers price		$     20.00			$        1,875,000
Direct materials	$     11.10			$        1,040,625
Direc Labor	$       4.50			$            421,875
($6*75%)
Variable overhead	$       1.20			$            112,500
($1.60*75%)
Supervision	$       0.80			$              75,000
(75000/93750 DRUMS)
Equipment rental	$       2.40			$            225,000
($225000/93750 drums)
Total cost	$     20.00	$     20.00		$        1,875,000	$        1,875,000
financial advantage from buying	$                                 -			$                                                         -
this is a indifferent decision
Ques 3
	Differential costs per drum			Total Differential costs -125000
	Make	Buy		Make	Buy
Outside suppliers price		$     20.00			$        2,500,000
Direct materials	$     11.10			$        1,387,500
Direc Labor	$       4.50			$            562,500
($6*75%)
Variable overhead	$       1.20			$            150,000
($1.60*75%)
Supervision	$       0.60			$              75,000
(75000/125000 DRUMS)
Equipment rental	$       1.80			$            225,000
($225000/125000 drums)
Total cost	$     19.20	$     20.00		$        2,400,000	$        2,500,000
financial advantage from buying	$                          (0.80)			$                                           (100,000)
the company will gian $0.80 per drum when making the drums