Question

Kobe Company manufactures a part for its production cycle. The costs per unit for 20,000 units of this part are as follows:

Direct materials $15

Direct labor 12

Variable factory overhead 20

Unavoidable fixed factory overhead 18

Total cost $65

The Kobe Company has been approached by a supplier who claims it can sell Kobe Company 20,000 units of the same part for $940,000.

Required:

a. Assuming there is no alternative use for the facilities, how much money would Kobe Company save by buying the part?

b. Assuming the facilities can be rented out for $10,000 per year, should Kobe Company buy the part, and if so, how much money would be saved?

c. Are there any other factors Kobe Company should consider?

Answer 1

1. When the company has the choice of making a product or buying it, only the relevant costs are considered while making calculations.Relevant costs are the costs that are incurred only when making specific business decisions.

In short, the additional costs for making additional unit is the relevant cost. All the variable costs are the relevant costs as they are incurred on the basis of units produced. If the specific fixed cost in incurred for the new project, it also becomes the relevant cost as it is spent only for that new project.All the other fixed costs which were spent even before taking up the new projects are the irrelevant costs.

Therefore, the relevant cost of production of 20,000 units:

Particulars		Amount
Direct Material per unit	A	$15.00
Direct Labor per unit	B	$12.00
Variable overhead per unit	C	$20.00
Relevant cost per unit	D=A+B+C	$47.00
Total units	E	20,000
Relevant cost 2,500 units	F =D*E	$940,000
Buying cost for 20,000 units		$940,000

As the relevant cost of production i.e. $940,000 is same as purchasing cost i.e. $940,000, hence the company will save NIL i.e. $0 by buying the part.

b. Yes, If the facilities can be rented out for $10,000 per year, the Kobe company should purchase the parts as it will result in increase in the revenue by $10,000 as the relevant costs is same as the purchasing cost but renting out the facility will yield $10,000 more per year.

c. The other things that Kobe Company should consider before purchasing the parts is the quality of the parts to be pruchased, reputation or worthiness of the supplier, timing of delivery i.e. whether they will be delivered on the time or not etc.