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 $4.85 less than it costs us to manufacture the drums in our own plant. Since we use 50,000 drums a year, that would be an annual cost savings of $242,500.” Antilles Refining’s current cost to manufacture one drum is given below (based on 50,000 drums per year):

		Cost per Drum
Direct materials	$	11.20
Direct labour		7.00
Variable overhead		1.75
Fixed overhead ($3.00 general company overhead, $1.85     depreciation, and, $1.05 supervision)		5.90
Total cost per drum	$	25.85

      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 labour and variable overhead costs by 20%. 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.
    The company’s total general company overhead would be unaffected by this decision. (Round all intermediate calculations to 2 decimal places.)

Required:
1. To assist the managing director in making a decision, prepare an analysis showing the total cost and the cost per drum for each of the two alternatives given above. Assume that 50,000 drums are needed each year.

a. What will be the total relevant cost of 50,000 drums if they are manufactured internally as compared to being purchased?

b. What would be the per unit cost of each drum manufactured internally? (Round your answer to 2 decimal places.)

c. Which course of action would you recommend to the managing director?

• Purchase from the outside supplier

• Manufacture internally

• Indifferent between the two alternatives

2a-1. What will be the total relevant cost of 75,000 drums if they are manufactured internally?

2a-2. What would be the per unit cost of drums? (Round your answer to 2 decimal places.)

2a-3. What course of action would you recommend if 75,000 drums are needed each year?

• Indifferent between the two alternatives

• Manufacture internally

• Purchase from the outside supplier

2b-1. What will be the total relevant cost of 105,000 drums if they are manufactured internally?

2b-2. What would be the per unit cost of drums? (Round your answer to 2 decimal places.)

2b-3. What course of action would you recommend if 105,000 drums are needed each year?

• Manufacture internally

• Purchase from the outside supplier

• Indifferent between the two alternatives

Answer 1

1a,

Relevant Cost
Direct Material	$      560,000
Direct Labor	$      280,000
Variable Overhead	$         70,000
Rent of New Equipment	$      157,500
Supervision	$         52,500
Total Relevant Cost	$   1,120,000

1b.

Per unit cost of drum = $1120000 / 50000 = $22.40 per drum

1c.
Purchase from the outside supplier

2a-1

Relevant Cost
Direct Material	$      840,000
Direct Labor	$      420,000
Variable Overhead	$      105,000
Rent of New Equipment	$      157,500
Supervision	$         52,500
Total Relevant Cost	$   1,575,000

2a-2

Per unit cost of drum = $1575000 / 75000 = $21 per drum

2a-3
Indifferent between the two alternatives

2b-1

Relevant Cost
Direct Material	$   1,176,000
Direct Labor	$      588,000
Variable Overhead	$      147,000
Rent of New Equipment	$      157,500
Supervision	$         52,500
Total Relevant Cost	$   2,121,000

2b-2

Per unit cost of drum = $2121000 / 105000 = $20.20 per drum

2b-3
Manufacture internally