Question

Rey Company manufactures 4,000 units of processor chip, A-772, each year for use on its production line. At this level of activity, the cost per unit of processor chip is:

Direct materials $ 354

Direct labor 20

Variable manufacturing overhead 8

Fixed manufacturing overhead 80

Total manufacturing cost per unit $ 462

An outside supplier has offered to sell all units of processor chip the company requires. If the company decided to discontinue making processor chip, 5% of the above fixed manufacturing overhead costs could be avoided.

The company could use the facilities presently devoted to the production of processor chip to increase production of another product by 2,500 units, which would yield an additional contribution margin of $80,000 annually.

Q:) What is the maximum price the company would be willing to pay the outside supplier for processor chip?

Answer 1

Answer)

Calculation of Maximum Price that the company will be willing to pay to outside supplier

Maximum price that the company will be willing to pay should be based on the relevant cost. Relevant cost includes cost to be incurred due to manufacture of processor chip less benefit to be achieved due to manufacture of processor chip.

Particulars	Amount (In $)
Cost to be incurred due to manufacture of processor chips:
Direct Material (4,000 units X $ 354 per unit)	1,416,000
Direct Labor (4,000 units X $ 20 per unit)	80,000
Variable manufacturing overhead (4,000 units X $ 8 per unit)	32,000
Avoidable fixed manufacturing overhead (4,000 units X $ 80 per unit X 5%)	16,000
Total Cost to be incurred due to manufacture of processor chips	1,544,000
Less: Benefit to be achieved
Additional Contribution margin earned	80,000
Maximum Price that the company will be willing to pay to outside supplier	1,464,000
Number of units transferred	4,000
Maximum Price per unit	366.00

Therefore maximum price that the company will be willing to pay to outside supplier is $ 366 per unit

Note: Unavoidable Fixed cost (i.e. 95% of total manufacturing cost) should not be considered in above analysis as it is a sunk cost.