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 $17 per drum, we would be paying $6.85 less than it costs us to manufacture the drums in our own plant. Since we use 50,000 drums a year, that would be an annual cost savings of $342,500.” Antilles Refining’s current cost to manufacture one drum is given below (based on 50,000 drums per year):

Direct materials	$	10.40
Direct labor		6.50
Variable overhead		1.50
Fixed overhead ($2.90 general company overhead, $1.65 depreciation, and, $0.90 supervision)		5.45
Total cost per drum	$	23.85

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 $135,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $17 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 40%. The old equipment has no resale value. Supervision cost ($45,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 125,000 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 50,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

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

3. Assuming that 125,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

Answer 1

Part 1:
Manufacturing cost:
Direct materials	10.40
Dirrect labour (6.50 x 60%)	3.90
Variable overhead (1.50 x 60%)	0.90
Variable cost of each drum	15.20
Total variable cost of 50000 drums	760,000.00
Equipment rent	135,000.00
Supervision cost	45,000.00
General company overhead (50000 x 2.9)	145,000.00
Total cost to make 50000 drums	1,085,000.00
Buying cost:
Purchase price (50000 x 17)	850,000.00
Add: General company overhead (50000 x 2.9)	145,000.00
Total cost to buy 50000 drums	995,000.00
Savings in cost of buying (1085000 - 995000)	90,000.00

Thus, the company should purchase 50,000 drums from outside supplier as it would result in saving of $90000 in overall costs.

Part 2:
Manufacturing cost:
Direct materials	10.40
Dirrect labour (6.50 x 60%)	3.90
Variable overhead (1.50 x 60%)	0.90
Variable cost of each drum	15.20
Total variable cost of 100000 drums	1,520,000.00
Equipment rent	135,000.00
Supervision cost	45,000.00
General company overhead (50000 x 2.9) as it is fixed cost	145,000.00
Total cost to make 100000 drums	1,845,000.00
Buying cost:
Purchase price (100000 x 17)	1,700,000.00
Add: General company overhead (50000 x 2.9) as it is fixed costs	145,000.00
Total cost to buy 100000 drums	1,845,000.00
Savings in cost of buying (1845000 -1845000)	-

Since, there is no difference between the cost of manufacturing and cost to buy 100000 drums hence, the company can either manufacture or buy the drums as there will be neither savings in costs nor excess costs.

Part 3:
Manufacturing cost:
Direct materials	10.40
Dirrect labour (6.50 x 60%)	3.90
Variable overhead (1.50 x 60%)	0.90
Variable cost of each drum	15.20
Total variable cost of 125000 drums	1,900,000.00
Equipment rent	135,000.00
Supervision cost	45,000.00
General company overhead (50000 x 2.9) as it is fixed cost	145,000.00
Total cost to make 125000 drums	2,225,000.00
Buying cost:
Purchase price (125000 x 17)	2,125,000.00
Add: General company overhead (50000 x 2.9)	145,000.00
Total cost to buy 50000 drums	2,270,000.00
Savings in cost of buying (2225000 - 2270000)	(45,000.00)

Since, instead of savings the company will incur $45,000 extra if it decides to buy hence, the company should manufacture 125,000 drums.