Question

22) Gonzalez Company produces a part that is used in the manufacture of one of its products. The annual costs associated with the production of 5,000 units of this part are as follows:

Direct materials                                    $100,000

Direct labor                                              56,000

Variable factory overhead                         72,000

Fixed factory overhead                           168,000

Total costs                                            $396,000

Of the fixed factory overhead costs, $72,000 are avoidable. Another company has offered to sell 5,000 units of the same part to Gonzalez for $70.00 per unit. The facilities currently used to make the part can be rented out to another manufacturer for $72,000 per year. What should Gonzalez Company do?

A) Make the part to save $22,000.

B) Make the part to save $50,000.

C) Buy the part and rent the facilities to save $22,000.

D) Buy the part and rent the facilities to save $72,000.

Answer 1

Relevant costs are costs which are incurred only when a decision is taken. In the present problem, we have to only consider the relevant costs related to production which will be incurred only if production is done

Fixed factory overhead which is avoidable will only form part of relevant cost as unavoidable fixed overhead is a sunk cost as it has to be incurred by the organization even if production is not done

Rent which could have been earned if the factory was not used for production is an opportunity cost of production and so will form part of relevant cost of production

These costs are as follows:

Direct materials $100,000 + Direct labor $56,000 + Variable factory overhead $72,000 + Avoidable fixed overhead $72,000 + Opportunity cost of rent foregone $72,000

= $372,000

Cost of buying

= Number of units x Price per unit

= 5,000 x $70

= $350,000

So, Net benefit of buying the part and renting the facility

= Relevant cost of Cost of production – Cost of buying

= $372,000 - $350,000

= $22,000

So, as per above calculations, option C is the correct option