Question

he Roosevelt Company presently makes 27,000 units of a certain component each year for use on its production line.  The cost per unit for the component at this level of activity is as follows

Direct materials.................................$4.20

Direct Labor.....................................$12.00

Variable factory overhead................. $5.80

Fixed factory overhead......................$6.50

Roosevelt has received an offer from an outside supplier who is willing to provide 27,000 units of this component at a price of $25 per component.  Assume that if the component is purchased from the outside supplier, $35,100 of annual fixed factory overhead could be avoided and the facilities now being used to make the component could be rented to another company for $64,800 per year. If Roosevelt chooses to buy the component from the outside supplier under these circumstances, how much would annual net income increase or decrease by?

Answer 1

Annual production = 27,000 components

Make Option:

Direct Materials: $4.20 per component

Direct Labor: $12.00 per component

Variable factory overhead: $5.80 per component

Fixed factory overhead: $6.50 per component

Total cost = 4.20 + 12.00 + 5.80 + 6.50 = $28.50 per component

Total cost = per component cost*annual production = 28.50*27000 = $769500

Buy Option:

Purchase price is: $25 per component.

Quantity = 27000

Buy option can avoid the fixed cost by $35,100. Hence the current fixed cost = 175500 – 35100 = $140400

So total cost = purchase price*quantity + overhead

= 25*27000 + 140400

= 675000 + 140400

= $815400

With Buy option, the equipment can be rented to another company for $64,800

Hence the net cost of buying = Cost of purchase – income from rent = 815400 – 64800 = $750600

So,

Net cost of Making = $769500

Net cost of Buying = $750600

So, Profit from Buying Option = cost of making – cost of buying = $18900

Annual net income will increase by $18,900

Answer is: $18,900

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