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 $20 per drum, we would be paying $6.40 less than it costs us to manufacture the drums in our own plant. Since we use 65,000 drums a year, that would be an annual cost savings of $416,000.” Antilles Refining’s current cost to manufacture one drum is given below (based on 65,000 drums per year):

Direct materials	$	10.50
Direct labor		8.00
Variable overhead		2.00
Fixed overhead ($3.20 general company overhead, $1.80 depreciation, and $0.90 supervision)		5.90
Total cost per drum	$	26.40

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 $175,500 per year.

Alternative 2: Purchase the drums from an outside supplier at $20 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 35%. The old equipment has no resale value. Supervision cost ($58,500 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 90,000 drums per year.

The company’s total general company overhead would be unaffected by this decision.

Required:

1. Assuming that 65,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 78,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 90,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

(For all requirements, enter any "disadvantages" as a negative value. Do not round intermediate calculations.)

	Production Needs Financial Advantage (Disadvantage) of Buying the Drums 1. 65,000 drums $ 2. 78,000 drums $ 3. 90,000 drums $

Answer 1

A product's make or buy decision depends upon lots of costs associated with it. To make a product, it requires to consider all the direct as well as indirect costs of manufacturing it. To buy the product, the cost of buying it is considered. The manufacturer has to take the decision to buy or make, by considering the costs of both decisions and choose the one having more financial advantage.

Working notes:

The new equipment would reduce direct labor and variable overhead costs by 35%.
Hence, Direct labor per unit = $8.00 - 35% = $5.20
Variable overhead per unit = $2.00 - 35% = $1.30

General company overhead is not considered while determining the cost of the drum.
Depreciation is also not considered because it is a sunk cost. Normally, sunk costs are not considered in taking future business decisions.
Supervision cost is considered because it is avoidable if the product is purchased from outside.