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 $21 per drum, we would be paying $4.85 less than it costs us to manufacture the drums in our own plant. Since we use 50,000 drums a year, that would be an annual cost savings of $242,500.” Antilles Refining’s current cost to manufacture one drum is given below (based on 50,000 drums per year):

Direct materials	$	11.20
Direct labor		7.00
Variable overhead		1.75
Fixed overhead ($3.00 general company overhead, $1.85 depreciation, and $1.05 supervision)		5.90
Total cost per drum	$	25.85

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 $157,500 per year.

Alternative 2: Purchase the drums from an outside supplier at $21 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 20%. The old equipment has no resale value. Supervision cost ($52,500 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 105,000 drums per year.

The company’s total general company overhead would be unaffected by this decision.

Required:

1. Assuming that 50,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 75,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 105,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

Answer 1

Solution:

(1) 50000 Drums are needed:-

Making Cost:-
Direct Material (50000 * 11.20)	560000
Direct Labor (7*80%) * 50000	280000
Variable O/H (1.75*80%) * 50000	98000
Supervision Cost	70000
Rent for new Equipment	157500	1165500
(-) Purchase Cost :-
Purchase Price (21 * 50000)		1050000
Advantage of Buying the Drums from Outside Supplier		115500

(2) 75000 Drums are needed:-

Making Cost:-
Direct Material (75000 * 11.20)	840000
Direct Labor (7*80%) * 75000	420000
Variable O/H (1.75*80%) * 75000	105000
Supervision Cost	52500
Rent for new Equipment	157500	1575000
(-) Purchase Cost :-
Purchase Price (21 * 75000)		1575000
Advantage of Buying the Drums from Outside Supplier		---------

(3) 105000 Drums are needed:-

Making Cost:-
Direct Material (105000 * 11.20)	1176000
Direct Labor (7*80%) * 105000	588000
Variable O/H (1.75*80%) * 105000	147000
Supervision Cost	52500
Rent for new Equipment	157500	2121000
(-) Purchase Cost :-
Purchase Price (21 * 105000)		2205000
Disadvantage of Buying the Drums from Outside Supplier		-84000