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.

Answer 1

The incremental savings (loss) of buying the valves is $750 per unit

The total cost for making the valves internally and purchased from outside is in the computed below table:-

costs	Make	Buy
Variable cost:
Direct material	$920,000	0
Direct labor	$600,000	$600,000
Variable overhead	$300,000	0
Fixed costs:
Depreciation of equipment	$500,000	$500,000
Depreciation of building	$250,000	$250,000
Supervisory salaries	$300,000	$300,000
Other:
Cost savings on lease	0	($55,000)
Cost of buying valves	0	$2,000,000
Total costs	$2,870,000	$3,595,000

Thus, total cost of buying is $3,595,000 and making internally is $2,870,000.

Which means that incremental costs from buying outside will be:

=$2,870,000 - $3,595,000

= -$725,000 or -$725 per unit

Note: - Direct labor, Supervisor cost and depreciation on building and equipment will be incurred even if we buy the valve from outside. The labor and supervisors are reassigned to other areas. Therefore, these costs will be incurred while buying from outside and it will not make any effect on incremental saving in buying.