Question

“In my opinion, we ought to stop making our own drums and accept that outside supplier’s offer,” said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. “At a price of $21 per drum, we would be paying $6.05 less than it costs us to manufacture the drums in our own plant. Since we use 70,000 drums a year, that would be an annual cost savings of $423,500.” Antilles Refining’s current cost to manufacture one drum is given below (based on 70,000 drums per year):

Direct materials	$	11.00
Direct labor		8.00
Variable overhead		2.00
Fixed overhead ($3.20 general company overhead, $1.95 depreciation, and, $0.90 supervision)		6.05
Total cost per drum	$	27.05

A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are:

Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $189,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $21 per drum.

The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 30%. The old equipment has no resale value. Supervision cost ($63,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 100,000 drums per year.

The company’s total general company overhead would be unaffected by this decision. (Round all intermediate calculations to 2 decimal places.)

Required:

1. Assuming that 70,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 84,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 100,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

(For all requirements, enter any "disadvantages" as a negative value. Do not round intermediate calculations.)

Answer 1

(1) 70000 Drums are needed:-

Making Cost:-
Direct Material (70000 * 11)	770000
Direct Labour (8*70%) * 70000	392000
Variable O/H (2*70%) * 70000	98000
Supervision Cost	63000
Rent for new Equipment	189000	1512000
(-) Purchase Cost :-
Purchase Price (21 * 70000)		1470000
Advantage of Buying the Drums from Outside Supplier		42000

(2) 84000 Drums are needed:-

Making Cost:-
Direct Material (84000 * 11)	924000
Direct Labour (8*70%) * 84000	470400
Variable O/H (2*70%) * 84000	117600
Supervision Cost	63000
Rent for new Equipment	189000	1764000
(-) Purchase Cost :-
Purchase Price (21 * 84000)		1764000
Advantage of Buying the Drums from Outside Supplier		---------

(3) 100000 Drums are needed:-

Making Cost:-
Direct Material (100000 * 11)	1100000
Direct Labour (8*70%) * 100000	560000
Variable O/H (2*70%) * 100000	140000
Supervision Cost	63000
Rent for new Equipment	189000	2052000
(-) Purchase Cost :-
Purchase Price (21 * 100000)		2100000
Disadvantage of Buying the Drums from Outside Supplier		-48000