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 $5.45 less than it costs us to manufacture the drums in our own plant. Since we use 85,000 drums a year, that would be an annual cost savings of $463,250.” Antilles Refining’s current cost to manufacture one drum is given below (based on 85,000 drums per year):

Direct materials	$	10.70
Direct labor		5.50
Variable overhead		1.50
Fixed overhead ($3.70 general company overhead, $2.05 depreciation, and $1.00 supervision)		6.75
Total cost per drum	$	24.45

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 $255,000 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 30%. The old equipment has no resale value. Supervision cost ($85,000 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.

Required:

1. Assuming that 85,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 100,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 125,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

Answer 1

Particulars	Cost Per unit	Units	Units	Units	Working/ Remarks
Quantity		85,000	1,00,000	1,25,000	A
		Amount in $	Amount in $	Amount in $
Cost under Alternative 1
Rent		2,55,000	2,55,000	2,55,000	Given
Cost to manufacture
Direct materials	10.7	9,09,500	10,70,000	13,37,500	A * Direct Material Cost per unit
Direct labor	3.85	3,27,250	3,85,000	4,81,250	A * Direct Labor Cost per unit (Refer Note 1)
Variable overhead	1.05	89,250	1,05,000	1,31,250	A * Variable Cost per unit (Refer Note 1)
Fixed Overhead
General Company OH		3,14,500	3,14,500	3,14,500	Per unit cost of $ 3.7 * 85,000 Drums
Depreciation		-	-	-
Supervision		85,000	85,000	85,000	Given
Total Cost- Alternative 1		19,80,500	22,14,500	26,04,500	B
Cost under Alternative 2
Purchase cost	19	16,15,000	19,00,000	23,75,000	A * Purchase Cost per unit
Total General Company Overhead		3,14,500	3,14,500	3,14,500	Per unit cost of $ 3.7 * 85,000 Drums
Total Cost- Alternative 2		19,29,500	22,14,500	26,89,500	C
Financial Advantage / (Disadvantage)		51,000	-	-85,000	D = (B - C)
Conclusion		Alternative 2 is better	Both at par	Alternative 1 is better

Note 1: Reduced costs under Alternative 1
Particulars	Direct Labor under Alternative 1	Variable Cost under Alternative 1
Current cost	5.5	1.5
Less: reduction by 30% due to new equipment	1.65	0.45
Reduced Cost	3.85	1.05