Question

Mohave Corp. is considering outsourcing production of the umbrella tote bag included with some of its products. The company has received a bid from a supplier in Vietnam to produce 8,000 units per year for $7.50 each. Mohave has the following information about the cost of producing tote bags:

Direct materials	$	3
Direct labor		2
Variable manufacturing overhead		1
Fixed manufacturing overhead		2
Total cost per unit	$	8

Mohave has determined that all variable costs could be eliminated by outsourcing the tote bags, while 60 percent of the fixed overhead cost is unavoidable. At this time, Mohave has no specific use in mind for the space currently dedicated to producing the tote bags.   

Required:
1. Compute the difference in cost between making and buying the umbrella tote bag.

	Differential Cost of Making Versus Buying Favors Making

    

2. Should Mohave buy the tote bags or continue to make them?

	Make
	Buy

   

3-a. Suppose that the space Mohave currently uses to make the bags could be utilized by a new product line that would generate $10,000 in annual profits. Recompute the difference in cost between making and buying the umbrella tote bag.

      

	Differential Cost of Making Versus Buying Favors Buying

3-b. Does this change your recommendation to Mohave?

	No
	Yes

Answer 1

Requirement 1

Differential Analysis
	Make	Buy	Income Increase(decrease)
Direct material	$ 24,000.00		$    24,000.00
Direct labor	$ 16,000.00		$    16,000.00
Variable Manufacturing Overheads	$    8,000.00		$      8,000.00
Avoidable Fixed Cost	$    6,400.00		$      6,400.00
Purchase price		$ 60,000.00	$ (60,000.00)
Total Relevant Cost	$ 54,400.00	$ 60,000.00	$    (5,600.00)

Differential cost of making Vs buying =$5600 in favor of making.

Cost of making is less than cost of manufacturing.

Avoidable overhead cost is a cost of manufacturing Umbrella tote bag. This is because this cost could be avoided if bags are purchased. We can say that avoidable fixed overhead is like other variable cost that will be saved if no production is done.

Requirement 2

Answer--- Make

Requirement 3

Differential Analysis
	Make	Buy	Income Increase(decrease)
Direct material	$          24,000.00		$           24,000.00
Direct labor	$          16,000.00		$           16,000.00
Variable Manufacturing Overheads	$            8,000.00		$             8,000.00
Avoidable Fixed Cost	$            6,400.00		$             6,400.00
Opportunity cost	$          10,000.00		$           10,000.00
Purchase price		$        60,000.00	$         (60,000.00)
Total Relevant Cost	$          64,400.00	$        60,000.00	$             4,400.00

Differential cost of making Vs buying =$4400 in favor of Buying.

Requirement 4

Answer---Yes.

This change also changes my recommendation from making to buying because buying gives more benefit.

Working note

Differential Analysis
	Make	Buy
Direct material	=8000*3
Direct labor	=8000*2
Variable Manufacturing Overheads	=8000*1
Avoidable Fixed Cost	=8000*0.8
Purchase price		=8000*7.5