Question

Carvey Company manufactures a variety of ballpoint pens. The company has just received an offer from an outside supplier to provide the ink cartridge for the company’s pen line, at a price of $0.60 per dozen cartridges. The company is interested in this offer because its own production of cartridges is at capacity. Carvey Company estimates that if the supplier’s offer were accepted, the direct labor and variable manufacturing overhead costs of the pen line would be reduced by 10% and the direct materials cost would be reduced by 20%. Under present operations, Carvey Company manufactures all of its own pens from start to finish. The pens are sold through wholesalers at $4 per box. Each box contains one dozen pens. Fixed manufacturing overhead costs charged to the pen line total $30,000 each year. (The same equipment and facilities are used to produce several pen lines.) The present cost of producing one dozen pens (one box) is given below: Direct materials $ 1.30 Direct labor 1.10 Manufacturing overhead 0.60 * Total cost $ 3.00 * Includes both variable and fixed manufacturing overhead, based on production of 100,000 boxes of pens each year. 2. What is the maximum price that Carvey Company should be willing to pay the outside supplier per dozen cartridges? 3.Due to the bankruptcy of a competitor, Carvey Company expects to sell 150,000 boxes of pens next year. As previously stated, the company presently has enough capacity to produce the cartridges for only 100,000 boxes of pens annually. By incurring $39,000 in added fixed cost each year, the company could expand its production of cartridges to satisfy the anticipated demand for pens. The variable cost per unit to produce the additional cartridges would be the same as at present. a. Under these circumstances, how many boxes of cartridges should be purchased from the outside supplier and how many should be made by Carvey? b. Compute the total relevant cost for the following alternatives.

Answer 1

2) The maximum price that Carvey Company should be willing to pay the outside supplier per dozen cartridges will be equal to reduction in variable cost per dozen cartridges.

Reduction in Direct Material cost = $1.30*20% = $0.26

Reduction in Direct labor cost = $1.10*10% = $0.11

Now we need to seperate manufacturing overhead of $0.60 per dozen cartridge into fixed and variable manufacturing overhead.

Fixed Manufacturing Overhead = $30,000/100,000 = $0.30

Variable manufacturing Overhead = $0.60 - $0.30 = $0.30 per dozen

Reduction in variable manufacturing overhead = $0.30*10% = $0.03

Total reduction in cost = $0.26+$0.11+$0.03 = $0.40 per dozen

Therefore the maximum price that Carvey Company should be willing to pay is $0.40 per dozen cartridges.

3) a) The total reduction in variable cost per dozen cartridge is $0.40 and price offered by the supplier is $0.60, Thus upto 100,000 dozens of cartridge it is beneficial to produce cartridge internally.

But if additional 50,000 are required to produce then additional fixed cost of $39,000 will need to incur and by purchasing 50,000 dozens from supplier additional cost of $39,000 will be saved

Total reduction in cost for 50,000 dozens = $0.40 per dozen+($39,000/50,000)

= $0.40+$0.78 = $1.18 per dozen

Hence reduction in cost is more than the purchase cost of $0.60 per dozen. 50,000 dozens should be purchased from supplier.

100,000 boxes should be purchased from the outside supplier and 50,000 boxes should be made by Carvey.

b)There are three alternatives

1. Produce all cartridges internally
2. Purchase all cartridges externally
3. Produce the cartridges as per 3a (i.e. 100,000 produced and 50,000 purchased)

Relevant cost for alternative 1 (all produced internally) = (Variable cost*Cartridges)+Relevant Fixed cost

= [150,000*(1.3+1.1+0.3)]+$39,000

= (150,000*$2.70)+$39,000 = $444,000

Relevant cost for alternative 2 (all purchased externally) = (Variable cost*Cartridges)+Purchase cost

= [150,000*(1.04+0.99+0.27)]+(150,000*$0.60)

= (150,000*$2.30)+$90,000 = $435,000

Relevant cost for alternative 3 (as per 3a) = (Variable cost*Cartridges)+Purchase cost

= (100,000*$2.70)+(50,000*$2.30)+(50,000*0.60)

= $270,000+$115,000+$30,000 = $415,000

Thus alternative 3 should be choosed because it includes lower cost (i.e. $415,000)

(As fixed cost of $30,000 will continue to occur in all the three alternative, it is not relevant for decision)