Question

Howell Corporation produces an executive jet for which it currently manufactures a fuel valve; the cost of the valve is indicated below:

	Cost per Unit
Variable costs
Direct material	$920
Direct labor	600
Variable overhead	300
Fixed costs
Depreciation of equipment	500
Depreciation of building	250
Supervisory salaries	300

The company has an offer from Duvall Valves to produce the part for $2,000 per unit and supply 1,000 valves (the number needed in the coming year). If the company accepts this offer and shuts down production of valves, production workers and supervisors will be reassigned to other areas. The equipment cannot be used elsewhere in the company, and it has no market value. However, the space occupied by the production of the valve can be used by another production group that is currently leasing space for $55,000 per year.

What is the incremental savings of buying the valves? (The answer should be stated in a per-unit format and is a positive number)

Round to two decimal places.

Your Answer:

Answer 1

First we will calculate the Total cost per unit if produced by the company.

Variable costs per unit = Direct material + Direct Labor + Variable overhead = 920 + 600 + 300 = 1,820

Total Cost of production per unit = Variable cost per unit + Supervisor salaries + Depreciation of equipment + Depreciation building

Total cost of production per unit = 1,820 + 300 + 500 + 250 = 2,870

Offered per unit Price = $2,000

Number of units = 1,000

Tota Price for all units = 2000 * 1000 = 2,000,000

If these 1,000 units were produced in-house, then it would cost = Number of units * Total cost of production per unit

Total cost of production in-house = 1,000 * 2,870 = 2,870,000

Now we will look at savings that can occur by not producing in-house.

Costs on workers and supervisors will still be incurred, hence, Salaries will be deducted from costs savings.

Equipment related costs will also be incurred irrespective of production in-house or outsourced, hence, its cost will be deducted from the cost savings

Company can save 55,000 per year by using the space assigned to valve production.

Hence, 55,000 is the additional cost savings due to outsourcing of production.

Total Incremental Cost Savings  = (In-house production cost - Offered Total Price from outside) + Savings on Lease payments - Costs still incurred on Salaries - Costs still incurred on Equipment

Total Incremental Cost Savings = 2,870,000 - 2,000,000 + 55,000 - 300 * 1000 - 500 * 1000

Total Incremental Cost Savings = 925,000 - 300,000 - 500,000

Total Incremental Cost Savings = $125,000

Per Unit Incremental Cost savings = Total Incremental Cost savings / Number of units

Per Unit Incremental Cost savings = 125,000 / 1,000

Per Unit Incremental Cost savings = $125

Hence, per unit Incremental costs savings is $125.