Question

Zion Manufacturing had always made its components in-house. However, Bryce Component Works had recently offered to supply one component, K2, at a price of $28 each. Zion uses 13,000 units of Component K2 each year. The cost per unit of this component is as follows:

Direct materials	$12.00
Direct labor	8.25
Variable overhead	4.50
Fixed overhead	6.00
Total	$30.75

Assume that 75% of Zion Manufacturing's fixed overhead for Component K2 would be eliminated if that component were no longer produced.

Required:

1. CONCEPTUAL CONNECTION: If Zion decides to purchase the component from Bryce, by how much will operating income increase or decrease?
  $

Which alternative is better?

2. CONCEPTUAL CONNECTION: Briefly explain how increasing or decreasing the 75% figure affects Zion’s final decision to make or purchase the component.

As the percentage of avoidable fixed cost increases (above 75%), total relevant costs of making the component increase, causing the “purchase” decision to be________ financially appealing (compared to the “make” option) than it was when the percentage was 75%. In other words, as the percentage increases, difference between the “purchase” and “make” options increases resulting in the “purchase” decision being even ________ attractive. Alternatively, as the percentage of avoidable fixed costs decreases, the “make” option eventually is ______ costly and ________ appealing financially as the “purchase” option. Finally, as the percentage of avoidable fixed cost decreases low enough and the total relevant costs of making the component decrease, the ______ option becomes the more financially appealing option

3. CONCEPTUAL CONNECTION: By how much would the per-unit relevant fixed cost have to decrease before Zion would be indifferent (i.e., incur the same cost) between “making” versus “purchasing” the component?

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Answer 1

Req. 1

Compute Relevant cost under both option as follows:

Particulars	Make	Buy
Relevant Costs:
Purchase cost		$28
Direct material	$12
Direct labor	$8.25
Variable overhead	$4.50
Total	$24.75	$28

If Zion purchases the component from Bryce, then its operating Income will decrease by $42,250 (13,000 units $3.25). As the differential cost to buy per unit is $3.25 higher than the make alternative.

___________________________________________________________________________

Req. 2

Compute Total relevant cost if 75% of fixed cost is eliminated:

Avoidable fixed cost = ($6 75%) = $4.5

Particulars	Make	Buy
Relevant Costs:
Purchase cost		$28
Direct material	$12
Direct labor	$8.25
Variable overhead	$4.50
Fixed overhead	$4.50
Total Relevant cost	$29.25	$28

If Zion purchases the component from Bryce, then its operating Income will Increase by $16,250 (13,000 units $1.25). As the differential cost to buy per unit is $1.25 less than the make option.

___________________________________________________________________________

Req. 3

Relevant fixed cost per unit must decrease by $1.25 from $4.5 to $3.25 to make Zion indifferent.

Particulars	Make	Buy
Relevant Costs:
Purchase cost		$28
Direct material	$12
Direct labor	$8.25
Variable overhead	$4.50
Fixed overhead	$3.25
Total Relevant cost	$28.00	$28

At the Indifferent point cost of buying from outside ann make are equal.