Question

Roberts currently manufactures a subcomponent that is used in its main product. A supplier has offered to supply all the subcomponents needed at a price of $42. Roberts currently produces 100,000 subcomponents at the following manufacturing costs:

	Per unit
Direct materials		$	15.00
Direct labor			9.00
Variable manufacturing overhead			10.00
Fixed manufacturing overhead			15.00
Unit cost		$	49.00

1. If Roberts has no alternative (no opportunity costs) uses for the manufacturing capacity, what would be the profit impact of buying the subcomponents from the supplier?

2. If Roberts has no alternative uses for the manufacturing capacity, what would be the maximum price per unit they would be willing to pay the supplier?

3. Now assume Roberts would avoid $150,000 in equipment leases and salaries if the subcomponent were purchased from the supplier. Now what would be the profit impact of buying from the supplier?

Answer 1

Answer a)

Calculation of relevant cost per unit to manufacture in the subcomponent in house

Relevant cost	Amount Per unit (In $)
Direct Materials	15
Direct Labor	9
Variable manufacturing overheads	10
Total	34

The relevant to manufacture the component (i.e. $ 34.00 per unit) is less than its purchase price (i.e. $ 42 per unit).

Therefore, if the company decides to buy the component from outside market, its Net income will decrease by:

Impact on Net Income = (Purchase price per unit – relevant cost of manufacture per unit) X number of subcomponents purchased

                                           = ($ 42 - $ 34) X 100,000 units

                                            = $ 800,000

Therefore the net income of the company will decrease by $ 800,000 if the company decides to purchase the component from outside supplier.

Note: Fixed manufacturing cost is a sunk cost (being unavoidable in nature) and thus the same has not been considered in above comparison.

Answer b)

Calculation of relevant cost per unit to manufacture in the subcomponent in house

Relevant cost	Amount Per unit (In $)
Direct Materials	15
Direct Labor	9
Variable manufacturing overheads	10
Total	34

If the manufacturing capacity has no alternative uses, the maximum price the company would be willing to pay to its supplier will be equal to its relevant cost to manufacture i.e. $ 34 per unit.

Note: Fixed manufacturing cost is a sunk cost (being unavoidable in nature) and thus the same has not been considered in above comparison.

Answer c)

Calculation of relevant cost per unit to manufacture in the subcomponent in house

Relevant cost	Amount Per unit (In $)	Total cost (in $)
Cost to be incurred
Direct Materials	15	1,500,000
Direct Labor	9	900,000
Variable manufacturing overheads	10	1,000,000
Avoidable fixed cost		150,000
Total		3,550,000

Therefore relevant cost to manufacture the component in house is $ 3,550,000.

Calculation of relevant cost to buy from outside supplier

Relevant cost to buy from outside supplier = $ 42.00 per unit X 100,000 units

                                                                               = $ 4,200,000

Impact on profit if the company decides to buy from outside supplier:

Total relevant to manufacture the component (i.e. $ 3,550,000) is less than its purchase price (i.e. $ 4,200,000).

Therefore, if the company decides to buy the component from outside market, its Net income will decrease by:

Decrease in Profit = Relevant cost to buy – Relevant cost to manufacture

                                 = $ 4,200,000 - $ 3,550,000

                                 = $ 650,000

Therefore the net income of the company will decrease by $ 650,000 if the company decides to purchase the component from outside supplier.