Question

Clean Cloths manufactures Washer and Dryers. The company produces the 5,000 drums used in its washers annually. The unit cost of making a drum is computed as follows:

Direct materials	$55.00
Direct labor	$25.00
Variable manufacturing overhead	$10.00
Fixed manufacturing overhead allocated ($100,000)	$20.00
Total	$110.00

An outside supplier has offered to supply all the drums for washers needed by Clean Cloths for $95.00. If Clean Cloths accepts the supplier offer $10 in direct materials and $5 in direct labor would be incurred by Clean Cloths to install the drum. These costs are already in the above $110 amount. If the offer is accepted eighty percent of the fixed manufacturing overhead can be eliminated.

Required:

a. Assuming there is no other use for the space currently being used to make the drums should

    the offer by the outside supplier be accepted. What is the dollar advantage or disadvantage?

    of accepting the offer.

.b. The space used to produce the drums can be used to produce 400 more washers. The

     contribution margin of each washer is $300. What is the dollar advantage or disadvantage?

     of making the extra washers.

c.   What is the maximum amount Clean Cloths should be willing to pay the outside supplier assuming the 400 extra washers can be produced in the space used to make the drums.

Answer 1

Formulas:

Contribution = Sales value - Variable expense

Contribution = $300, variable Cost = $110

Hence, sales Value = =300+110 = $410

a. The below table shows the comparison of manufacturing cost of Drum when made in the inhouse facility as well as at outside supplier

Cost Elements	Maufacturing in Inhouse Shop	Manufacturing Outside
Direct materials	$55.00	$0.00
Direct labor	$25.00	$0.00
Variable manufacturing overhead	$10.00
Fixed manufacturing overhead allocated ($100,000)	$20.00	$4.00
Supplier Cost		$95.00
Additional Direct Materials for Installation		$10.00
Additional Direct Labour for Installation		$5.00
Total	$110.00	$114.00

$4 is added to over head as manufacturing at outside supplier will reduce the over head alocation by 80%. ie 80% of $20 is $ 4.

As you can see, the total manufacturing cost of Drum is increased by $4 when done from outside vendor. this will reduce the Contribution margin for Clean Cloth; hence the outside vendor price cannot be accepted.

b. Space used for manufacturing drum is used to make 400 additional units of washers.

refer the below table for the Contribution Margin workout for 5000 and 5400 units

Case 1 - 5000 drums inhouse	Case2 - 5400 drums outside vendor
No: of Washers	5000	No: of Washers	5000
Contribution Margin	$300	Additional Washers	400
Variable Cost / Unit	$110	Total Washers	5400
Sales Value / Unit	$410	Sales Value / Unit	$410
Total Contribution	$1,500,000	Variable Cost /Unit	$113.70
		Contribution Margin	$296.30
		Total Contribution	$1,600,000

As you can see, the total Contribution Margin is increasing from $1,500,000 to 1,600,000. Hence the vendor price can be accepted as it generates more revenue and profit.

Here the manufacturing overhead allocation is reduced from $4 to $3.7 due to increase in quantity from 5000 to 5400 pcs. refer the table below for workout

Cost Elements	Maufacturing in Inhouse Shop	Manufacturing Outside	For 5400 units Outside Vendor
Direct materials	$55.00	$0.00	$0.00
Direct labor	$25.00	$0.00	$0.00
Variable manufacturing overhead	$10.00
Fixed manufacturing overhead allocated ($100,000)	$20.00	$4.00	$3.70
Supplier Cost		$95.00	$95.00
Additional Direct Materials for Installation		$10.00	$10.00
Additional Direct Labour for Installation		$5.00	$5.00
Total	$110.00	$114.00	$113.70

c. The max amount Clean Cloth would be willing to pay the outside vendor

It is when Clean cloth will make the same contribution as that of 5000 pcs

Contribution for 5000 pcs = $ 1,500,000.

Contribution / unit for 5400 units = 1500000/5400 = 277.78

Cost = 410- $277.78 = $ 132.22