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 $20 per drum, we would be paying $4.45 less than it costs us to manufacture the drums in our own plant. Since we use 65,000 drums a year, that would be an annual cost savings of $289,250.” Antilles Refining’s current cost to manufacture one drum is given below (based on 65,000 drums per year):

Direct materials $ 10.95

Direct labor 7.00

Variable overhead 1.60

Fixed overhead ($2.50 general company overhead, $1.60 depreciation, and, $0.80 supervision) 4.90

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 $156,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $20 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 25%. The old equipment has no resale value. Supervision cost ($52,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 100,000 drums per year. The company’s total general company overhead would be unaffected by this decision. (Round all intermediate calculations to 2 decimal places.)

Required:

1. Assuming that 65,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 80,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 100,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier? (For all requirements, enter any "disadvantages" as a negative value. Do not round intermediate calculations.)

Answer 1

Solution

Antilles Refining

1. Assuming that 65,000 drums are needed each year, determination of the financial advantage (disadvantage) of buying the drums from an outside supplier:

	Differential Cost per Drum		Total Differential Cost, 65,000 drums
	Make	Buy	Make	Buy
Outside Supplier's Price		$20		$1,300,000
Direct materials	$10.95		$711,750
Direct labor	5.25 (7x75%)		$341,250
Variable OH	1.2 ($1.6 x 75%)		$78,000
Relevant Fixed OH	$0.80		$52,000
Equipment Rental	2.4 (156,000/65,000)		$156,000
Total cost	$20.60	$20	$1,339,000	$1,300,000
Financial advantage of buying drums from an outside supplier	$20.60 - $20	$0.60 per drum	$39,000

Notes:

The use of new equipment would reduce direct labor and variable overhead by 25%, hence those costs are taken at 75%.

The equipment rental per drum = $156,000/65,000 drums = $2.40

The depreciation and general overhead costs are irrelevant for the following reasons,

The general overhead of $2.50 per drum would remain the same regardless of the company makes or buys the drums.

The depreciation of $1.60 represents sunk cost, also the machine is no more in working condition, hence irrelevant to the make or buy decision.

The supervision cost of $0.80 remains fixed at the normal volume of 65,000 drums. Hence, annual supervision cost = $0.80 x 65,000 = $52,000.

1. Assuming that 80,000 drums are needed each year, determination of the financial advantage (disadvantage) of buying the drums:

	Differential Cost per Drum		Total Differential Cost, 80,000 drums
	Make	Buy	Make	Buy
Outside Supplier's Price		$20		$1,600,000
Direct materials	$10.95		$876,000
Direct labor	5.25 (7x75%)		$420,000
Variable OH	1.2 ($1.6 x 75%)		$96,000
Relevant Fixed OH	0.65 ($52,000/80,000)		$52,000
Equipment Rental	1.95 ($156,000/80,000)		$156,000
Total cost	$20.00	$20	$1,600,000	$1,600,000
Financial advantage of buying drums from an outside supplier	$20 - $20	0	$0
The company would be indifferent between the two alternatives if 80,000 drums are needed each year.

1. Assuming that 100,000 drums are needed each year, determination of the financial advantage (disadvantage) of buying the drums:

	Differential Cost per Drum		Total Differential Cost, 100,000 drums
	Make	Buy	Make	Buy
Outside Supplier's Price		$20		$2,000,000
Direct materials	$10.95		$876,000
Direct labor	5.25 (7x75%)		$420,000
Variable OH	1.2 ($1.6 x 75%)		$96,000
Relevant Fixed OH	0.52 ($52,000/100,000)		$52,000
Equipment Rental	1.56 (156,000/100,000)		$156,000
Total cost	$19.48	$20	$1,948,000	$2,000,000
Financial disadvantage of buying drums from an outside supplier	$19.48 - $20	-$0.52	-$52,000
The company should rent the equipment and make the drums, if the annual demand is 100,000 drums.

The unit costs of both equipment rental and supervision would decrease as the annual requirement of drums increases. Hence, at 100,000 drums the company would have financial disadvantage in BUYING the drums from an outside supplier.