Question

Part A42 is used by Elgin Corporation to make one of its products. A total of 20,500 units of this part are produced and used every year. The company's Accounting Department reports the following costs of producing the part at this level of activity:

	Per Unit
Direct materials	$8.40
Direct labor	$9.80
Variable manufacturing overhead	$6.40
Supervisor's salary	$6.50
Depreciation of special equipment	$8.90
Allocated general overhead	$6.20

An outside supplier has offered to make the part and sell it to the company for $34.00 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including the direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company, none of which would be avoided if the part were purchased instead of produced internally. In addition, the space used to make part A42 could be used to make more of one of the company's other products, generating an additional segment margin of $27,500 per year for that product. What would be the impact on the company's overall net operating income of buying part A42 from the outside supplier?

A. Net operating income would decrease by $31,950 per year.

B. Net operating income would decrease by $204,150 per year.

C. Net operating income would increase by $27,500 per year.

D. Net operating income would decrease by $256,250 per year.

Answer 1

Correct answer---(A) Net operating income would decrease by $31,950

Calculation

Differential Analysis
	Make	Buy	Income Increase (Decrease)
Direct material	$ 1,72,200.00		$    1,72,200.00
Direct labor	$ 2,00,900.00		$    2,00,900.00
Variable Overhead	$ 1,31,200.00		$    1,31,200.00
Supervisor's salary	$ 1,33,250.00		$    1,33,250.00
Depreciation of special equipment			$                       -
Allocated general Overhead			$                       -
Outside purchase price		$        6,97,000.00	$ (6,97,000.00)
Opportunity cost	$     27,500.00		$       27,500.00
Total Cost	$ 6,65,050.00	$        6,97,000.00	$     (31,950.00)

Cost of buying is more than cost of making so if product is purchased from outside it would decrease net operating income.

Unavoidable fixed cost is not considered for this decision as unavoidable fixed cost would remain the same no matter what decision is taken.

Opportunity cost represent benefit to be achived from buying A42. This benefit is a cost for ‘Make’ alternative.