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 $19 per drum, we would be paying $5.35 less than it costs us to manufacture the drums in our own plant. Since we use 60,000 drums a year, that would be an annual cost savings of $321,000.” Antilles Refining’s current cost to manufacture one drum is given below (based on 60,000 drums per year):

Direct materials	$	10.45
Direct labor		7.00
Variable overhead		1.50
Fixed overhead ($3.00 general company overhead, $1.70     depreciation, and, $0.70 supervision)		5.40
Total cost per drum	$	24.35

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 $168,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $19 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 ($42,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 140,000 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 60,000 drums are needed each year.

  
     

a. What will be the total relevant cost of 60,000 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 120,000 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 120,000 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 140,000 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 140,000 drums are needed each year?

	Manufacture internally
	Purchase from the outside supplier
	Indifferent between the two alternatives

Answer 1

Solution 1a:

Differential Analysis - Making Drum (alt 1) or Buy Drum (Alt2) - 60000 drums
Particulars	Making Drum (Alt 1)	Buy Drum (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (60000*$19)	$0.00	$1,140,000.00	-$1,140,000.00
Direct material	$627,000.00	$0.00	$627,000.00
Direct Labor	$336,000.00	$0.00	$336,000.00
Variable overhead	$72,000.00	$0.00	$72,000.00
Supervisory Salary - Avoidable	$42,000.00	$0.00	$42,000.00
Equipment Rent - Avoidable	$168,000.00	$0.00	$168,000.00
Total cost	$1,245,000.00	$1,140,000.00	$105,000.00

Solution 1b:

Unit cost of each drum manufactured internally = $1,245,000 / 60000 = $20.75 per unit

Solution 1c:

Recommendation : Purchase from outside supplier

Solution 2a-1:

Differential Analysis - Making Drum (alt 1) or Buy Drum (Alt2) - 120000 drums
Particulars	Making Drum (Alt 1)	Buy Drum (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (120000*$19)	$0.00	$2,280,000.00	-$2,280,000.00
Direct material	$1,254,000.00	$0.00	$1,254,000.00
Direct Labor	$672,000.00	$0.00	$672,000.00
Variable overhead	$144,000.00	$0.00	$144,000.00
Supervisory Salary - Avoidable	$42,000.00	$0.00	$42,000.00
Equipment Rent - Avoidable	$168,000.00	$0.00	$168,000.00
Total cost	$2,280,000.00	$2,280,000.00	$0.00

Solution 2a-2:

Unit cost of each drum manufactured internally = $2,280,000 / 120000 = $19 per unit

Solution 2a-3:

Recommendation : Indifferent between two alternatives

Solution 2b-1:

Differential Analysis - Making Drum (alt 1) or Buy Drum (Alt2) - 140000 drums
Particulars	Making Drum (Alt 1)	Buy Drum (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (140000*$19)	$0.00	$2,660,000.00	-$2,660,000.00
Direct material	$1,463,000.00	$0.00	$1,463,000.00
Direct Labor	$784,000.00	$0.00	$784,000.00
Variable overhead	$168,000.00	$0.00	$168,000.00
Supervisory Salary - Avoidable	$42,000.00	$0.00	$42,000.00
Equipement Rent - Avoidable	$168,000.00	$0.00	$168,000.00
Total cost	$2,625,000.00	$2,660,000.00	-$35,000.00

Solution 2b-2:

Unit cost of each drum manufactured internally = $2,625,000 / 140000 = $18.75 per unit

Solution 2b-3:

Recommendation : Manufacture internally