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 $20 per drum, we would be paying $4.45 less than it costs us to manufacture the drums in our own plant. Since we use 65,000 drums a year, that would be an annual cost savings of $289,250.” Antilles Refining’s current cost to manufacture one drum is given below (based on 65,000 drums per year):

Direct materials	$	10.95
Direct labor		7.00
Variable overhead		1.60
Fixed overhead ($2.50 general company overhead, $1.60     depreciation, and, $0.80 supervision)		4.90
Total cost per drum	$	24.45

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 $156,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $20 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 25%. The old equipment has no resale value. Supervision cost ($52,000 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.)

1. To assist the managing director in making a decision, prepare an analysis showing the total cost and the cost per drum for each of the two alternatives given above. Assume that 65,000 drums are needed each year.   

a. What will be the total relevant cost of 65,000 drums if they are manufactured internally as compared to being purchased?

b. What would be the per unit cost of each drum manufactured internally? (Round your answer to 2 decimal places.)

c. Which course of action would you recommend to the managing director?

	Purchase from the outside supplier
	Manufacture internally
	Indifferent between the two alternatives

a-1. What will be the total relevant cost of 80,000 drums if they are manufactured internally?

a-2. What would be the per unit cost of drums?

2 a-3. What course of action would you recommend if 80,000 drums are needed each year?

	Indifferent between the two alternatives
	Manufacture internally
	Purchase from the outside supplier

b-1. What will be the total relevant cost of 100,000 drums if they are manufactured internally?

b-2. What would be the per unit cost of drums?

b-3. What course of action would you recommend if 100,000 drums are needed each year?

	Manufacture internally
	Purchase from the outside supplier
	Indifferent between the two alternatives

Answer 1

Ans.1a   

		units	cost/unit
		65000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead			1.20
Total Varriable Cost/Unit			17.40
Total Varriable Cost			1131000.00
Fixed Overhead
Supervision Cost			52000.00
New Equipment Rent			156000.00
			208000.00
Total Relevent Cost			1339000.00

Ans 1b

i		units	cost/unit
		65000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead			1.20
Total Varriable Cost/Unit			17.40
Total Varriable Cost			1131000.00
Fixed Overhead
Supervision Cost			52000.00
New Equipment Rent			156000.00
Total Fixed Cost			208000.00
Total Relevent Cost			1339000.00
Total Relevent Cost /Unit			20.60

Ans 1c

i		units	cost/unit
		65000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead			1.20
Total Varriable Cost/Unit			17.40
Total Varriable Cost			1131000.00
Fixed Overhead
Supervision Cost			52000.00
New Equipment Rent			156000.00
			208000.00
Total Relevent Cost			1339000.00
Total Relevent Cost /Unit			20.60
ii
Alternative 2
Cost of Purchase			20
Total Drum Purchased			65000
Total Cost of Purchase			1300000

It is concluded from both the alternatives that Alternative ii is better i.e to buy the prodoct at $20

Ans 2a

i			cost/unit
		80000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead				1.2
Total Varriable Cost/Unit				17.4
Total Varriable Cost			1392000
Fixed Overhead
Supervision Cost			52000
New Equipment Rent				156000
			208000
Total Relevent Cost				1600000

Ans 2b

i			cost/unit
		80000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead				1.2
Total Varriable Cost/Unit				17.4
Total Varriable Cost			1392000
Fixed Overhead
Supervision Cost			52000
New Equipment Rent				156000
			208000
Total Relevent Cost				1600000
Total Relevent Cost /Unit				20.00

Ans 2c

i			cost/unit
		80000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead				1.2
Total Varriable Cost/Unit				17.4
Total Varriable Cost			1392000
Fixed Overhead
Supervision Cost			52000
New Equipment Rent				156000
			208000
Total Relevent Cost				1600000
Total Relevent Cost /Unit				20.00
ii
Alternative 2
Cost of Purchase			20
Total Drum Purchased				80000
Total Cost of Purchase				1600000

It is indifferent between the 2 option

3a

i cost/unit 100000 Direct Material 10.95 Direct Labour 5.25 Direct Varriable overhead 1.2 Total Varriable Cost/Unit 17.4 Total Varriable Cost 1740000 Fixed Overhead Supervision Cost 52000 New Equipment Rent 156000 Total Fixed Cost 208000 Total Relevent Cost 1948000

Ans 3b

i			cost/unit
		100000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead				1.2
Total Varriable Cost/Unit				17.4
Total Varriable Cost			1740000
Fixed Overhead
Supervision Cost			52000
New Equipment Rent				156000
Total Fixed Cost			208000
Total Relevent Cost				1948000
Total Relevent Cost /Unit				19.48

Ans 3c

i			cost/unit
		100000
Direct Material			10.95
Direct Labour			5.25
Direct Varriable overhead				1.2
Total Varriable Cost/Unit				17.4
Total Varriable Cost			1740000
Fixed Overhead
Supervision Cost			52000
New Equipment Rent				156000
Total Fixed Cost			208000
Total Relevent Cost				1948000
Total Relevent Cost /Unit				19.48
ii
Alternative 2
Cost of Purchase			20
Total Drum Purchased				100000
Total Cost of Purchase				2000000

It is better to make 100000 unit internally as the relevant cost of production is $19.48 which is less than the purchase price of $ 20