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 $21 per drum, we would be paying $6.25 less than it costs us to manufacture the drums in our own plant. Since we use 75,000 drums a year, that would be an annual cost savings of $468,750.” Antilles Refining’s current cost to manufacture one drum is given below (based on 75,000 drums per year):

Direct materials	$	10.65
Direct labor		9.00
Variable overhead		1.60
Fixed overhead ($3.40 general company overhead, $1.90 depreciation, and, $0.70 supervision)		6.00
Total cost per drum	$	27.25

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 $157,500 per year.

Alternative 2: Purchase the drums from an outside supplier at $21 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 ($52,500 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 105,000 drums per year.

(Note from Dr. M: If the company stopped making the drums, they would lay off the supervisor. The paragraph above says that DM cost per drum and supervisor costs would not be affected by the new equipment. This means that, IF the company leases the new equipment and makes the drums, the DM cost per drum and supervisory cost would be the same as it currently is. But IF the company stops making the drums, then the DM cost per drum and supervisory costs would be eliminated.)

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 75,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 87,500 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 105,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

Answer 1

Solution 1:
Differential Analysis - Making Drum (alt 1) or Buy Drum (Alt2) - 75000 drums
Particulars	Making Drum (Alt 1)	Buy Drum (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (75000*$21)	$0.00	$1,575,000.00	-$1,575,000.00
Direct material	$798,750.00	$0.00	$798,750.00
Direct Labor	$506,250.00	$0.00	$506,250.00
Variable overhead	$90,000.00	$0.00	$90,000.00
Supervisory Salary - Avoidable	$52,500.00	$0.00	$52,500.00
Equipment Rent - Avoidable	$157,500.00	$0.00	$157,500.00
Total cost	$1,605,000.00	$1,575,000.00	$30,000.00
Solution 2:
Differential Analysis - Making Drum (alt 1) or Buy Drum (Alt2) - 87500 drums
Particulars	Making Drum (Alt 1)	Buy Drum (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (87500*$21)	$0.00	$1,837,500.00	-$1,837,500.00
Direct material	$931,875.00	$0.00	$931,875.00
Direct Labor	$590,625.00	$0.00	$590,625.00
Variable overhead	$105,000.00	$0.00	$105,000.00
Supervisory Salary - Avoidable	$52,500.00	$0.00	$52,500.00
Equipment Rent - Avoidable	$157,500.00	$0.00	$157,500.00
Total cost	$1,837,500.00	$1,837,500.00	$0.00
Solution 3:
Differential Analysis - Making Drum (alt 1) or Buy Drum (Alt2) - 105000 drums
Particulars	Making Drum (Alt 1)	Buy Drum (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (105000*$21)	$0.00	$2,205,000.00	-$2,205,000.00
Direct material	$1,118,250.00	$0.00	$1,118,250.00
Direct Labor	$708,750.00	$0.00	$708,750.00
Variable overhead	$126,000.00	$0.00	$126,000.00
Supervisory Salary - Avoidable	$52,500.00	$0.00	$52,500.00
Equipment Rent - Avoidable	$157,500.00	$0.00	$157,500.00
Total cost	$2,163,000.00	$2,205,000.00	-$42,000.00