Question

Futura Company purchases the 78,000 starters that it installs in its standard line of farm tractors from a supplier for the price of $12.30 per unit. Due to a reduction in output, the company now has idle capacity that could be used to produce the starters rather than buying them from an outside supplier. However, the company’s chief engineer is opposed to making the starters because the production cost per unit is $12.80 as shown below:

Per Unit Total Direct materials $ 6.00 Direct labor 3.00 Supervision 1.70 $ 132,600 Depreciation 1.30 $ 101,400 Variable manufacturing overhead 0.30 Rent 0.50 $ 39,000 Total product cost $ 12.80 If Futura decides to make the starters, a supervisor would have to be hired (at a salary of $132,600) to oversee production.

However, the company has sufficient idle tools and machinery such that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The total rent on the plant is $83,000 per period. Depreciation is due to obsolescence rather than wear and tear. Required:

What is the financial advantage (disadvantage) of making the 78,000 starters instead of buying them from an outside supplier?

Answer 1

Answer 1)

Calculation of Financial advantage (disadvantage) of making 78,000 starters instead of buying them

Make	Amount (In $)	Buy	Amount (In $)
Direct Materials (78,000 units X $ 6 per unit)	468,000	Purchase cost (78,000 units X $ 12.30 per unit)	959,400
Direct Labor (78,000 units X $ 3 per unit)	234,000
Variable manufacturing overhead (78,000 units X $ 0.30 per unit)	23,400
Additional supervisor's salary	132,600
Total relevant cost to Make	858,000	Total relevant cost to Buy	959,400

Since the relevant cost to Make (i.e. $ 858,000) is less than relevant cost to Buy (i.e. $ 959,400), if the company decides to make the starters in- house, it will have financial advantage of $ 101,400 (i.e. $ 959,400 - $ 858,000).

Notes:

· Allocated fixed overhead cost (i.e. Supervision, Depreciation of machine and Rent) is not a relevant cost to make starters as there is no additional expense (since the company has idle capacity) and change in allocation does not result in change in cash outflows. Thus these fixed costs should be charged to existing production.

· Additional supervisor’s salary is in addition to exiting supervision cost and since this will be incurred only if the company decides to make starters in-house, it is a relevant cost to make.