Question

Vernon Chemical Company makes a variety of cosmetic products, one of which is a skin cream designed to reduce the signs of aging. Vernon produces a relatively small amount (18,000 units) of the cream and is considering the purchase of the product from an outside supplier for $5.90 each. If Vernon purchases from the outside supplier, it would continue to sell and distribute the cream under its own brand name. Vernon’s accountant constructed the following profitability analysis:

Revenue (18,000 units × $15.00)	$	270,000
Unit-level materials costs (18,000 units × $1.90)		(34,200	)
Unit-level labor costs (18,000 units × $0.50)		(9,000	)
Unit-level overhead costs (18,000 × $0.40)		(7,200	)
Unit-level selling expenses (18,000 × $0.20)		(3,600	)
Contribution margin		216,000
Skin cream production supervisor’s salary		(66,000	)
Allocated portion of facility-level costs		(13,100	)
Product-level advertising cost		(48,000	)
Contribution to companywide income	$	88,900

Required

Identify the cost items relevant to the make-or-outsource decision.

What is the avoidable cost per unit if the outsourcing decision is taken? Should Vernon continue to make the product or buy it from the supplier?

Suppose that Vernon is able to increase sales by 11,000 units (sales will increase to 29,000 units). Calculate the total avoidable costs. At this level of production, should Vernon make or buy the cream?

Answer 1

Solution 1:

Cost items relevant to make of outsource decesion are those cost which can be avoided if company take outsource decision. These cost will include variable production cost and Production supervisor salary.

Relevant cost items for make or outsource decesions:

1. Unit level material cost

2. Unit level labor cost

3. Unit level overhead cost

4.Skin cream production supervisor’s salary

Computation of avoidable cost per unit for buy decision
Particualrs	Amount
Unit level Material cost	$34,200.00
Unit level Labor cost	$9,000.00
Unit level Overhead cost	$7,200.00
Skin cream production supervisor’s salary	$66,000.00
Total avoidable cost	$116,400.00
Number of units	$18,000.00
Avoidable cost per unit	$6.47

As price offered by supplier is $5.90 which lower than avoidable cost per unit of $6.47 , therefore Vernon should buy the product from outside supplier.

Computation of avoidable cost per unit for buy decision (Activity level - 29000 units)
Particualrs	Amount
Unit level Material cost	$55,100.00
Unit level Labor cost	$14,500.00
Unit level Overhead cost	$11,600.00
Skin cream production supervisor’s salary	$66,000.00
Total avoidable cost	$147,200.00
Number of units	$29,000.00
Avoidable cost per unit	$5.08

As avoidable cost per unit is lower than buying cost per unit, therefore at this level of production, Vernon should make the cream.