Question

Cherry Company makes telephones. Currently, Cherry makes all the components of the telephones in-house. An outside company has offered to supply one component, part number X76, for $15 each. Cherry uses 15,000 of these components per year. Costs of X76 are as follows: ​

Direct materials $2.00

Direct labor $2.00

Variable overhead $3.00

Fixed overhead $6.00 ​

Assume that all of the fixed overhead is allocated and cannot be avoided. Should Cherry purchase the part from the outside supplier?

a. Yes, income will increase by $200,500.

b. No, income will decrease by $145,500.

c. Yes, income will increase by $278,500.

d. Yes, income will increase by $140,200.

e. No, income will decrease by $120,000.

Answer 1

Answer)

Statement of Comparative Cost per unit of Component

Make in House	Amount per unit (in $)	Purchase from Outside	Amount per unit (in $)
Direct Material	2.00	Purchase cost	15.00
Direct Labour	2.00
Variable Overheads	3.00
Total	7.00	Total	15.00

Conclusion: Since the purchase cost per unit (i.e. $ 15.00) exceeds the per unit variable cost of manufacturing (i.e. $ 7.00), there will be an additional loss of $ 8.00 per unit in case the company wishes to stop in house production of component and buy from outside supplier. Since the annual requirement of the component is 15,000 units, the decline income of cherry company in case it plans to buy the component supplier will be $ 1,20,000 (i.e. $ 8.00 per unit X 15,000 units).

There the correct answer to the given Question is Option (e): No, income will decrease by $ 1,20,000.

Note: Fixed overhead being unavoidable in nature has not been considered while calculating Cost of manufacturing as it is a Sunk Cost ,being future cost, obligation of which has already been decided. It will be incurred with the same amount irrespective of whether the company manufactures in house or purchase from outside.