Question

Cotton Corp. currently makes 10,000 subcomponents a year in one of its factories. The unit costs to produce are:

	Per unit
Direct materials		$	34.50
Direct labor			15.00
Variable manufacturing overhead			21.50
Fixed manufacturing overhead			28.00
Total unit cost		$	99.00

An outside supplier has offered to provide Cotton Corp. with the 10,000 subcomponents at a $86.50 per unit price. Fixed overhead is not avoidable. If Cotton Corp. rejects the outside offer, what will be the effect on short-term profits?

Answer 1

Since Fixed overhead are not avoidable, we will compare variable cost of inhouse production with price of outside supplier.

Statement showing variable cost:

Particulars	Per unit
Direct Materials	$34.50
Direct Labor	$15
Variable manufacturing overheads	$21.50
Total Variable cost	$71.00

Variable cost of inhouse production is amounting to $71, which is far lower than the price stated by outside supplier i.e. $86.5.

The offer of outside supplier should be rejected and effect on short term profits will be NIL.

If Cotton Corp. would have accepted the offer then the profits would have been impacted negatively.