Question

Problem 11-28 Make or Buy Decisions [LO11-3]

“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 $22 per drum, we would be paying $3.50 less than it costs us to manufacture the drums in our own plant. Since we use 95,000 drums a year, that would be an annual cost savings of $332,500.” Antilles Refining’s current cost to manufacture one drum is given below (based on 95,000 drums per year):

Direct materials	$	10.60
Direct labor		8.00
Variable overhead		1.50
Fixed overhead ($2.70 general company overhead, $1.70 depreciation, and $1.00 supervision)		5.40
Total cost per drum	$	25.50

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 $285,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $22 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 20%. The old equipment has no resale value. Supervision cost ($95,000 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.

Required:

1. Assuming that 95,000 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

Cost / Unit Amount Amount Ans 1 Cost of 95000 Drums Particulars Direct Cost Direct Material Direct Labor Variable Overhead $10.60 $6.40 $1.20 $1,007,000 $ 608,000 $114,000 $1,729,000 Add: Fixed Overhead Rent for New Equipment Supervision (95000 x $1] Total Cost $285,000 $95,000 $380,000 $2,109,000 Drum Produced 95,000 Cost/Drum [$2109000 / 95000] $22.20 Manufacturing cost/drum $22.20 Purchase Cost/drum $22.00 Since there is a saving of $ 0.20/drum on purchase from Outside Supplier, the Company should go for Purchase from Outside Supplier Cost to Manufacture $22.20 Less: Buying from Outside $22.00 Financial Advantage/(disadvantage) of buying from outisde supplier 95000 95000 $2,109,000 $2,090,000 $19,000

Cost/Unit Amount Amount Ans 2 Cost of 100000 Drums Particulars Direct Cost Direct Material Direct Labor Variable Overhead $10.60 $6.40 $1.20 1,060,000 640,000 120,000 1,820,000 Add: Fixed Overhead Rent for New Equipment Supervision Total Cost 285,000 95,000 380,000 2,200,000 Drum Produced 100,000 Cost/Drum [$2200000 / 100000] $22.00 Manufacturing cost/drum $22.00 Purchase Cost/drum $22.00 Since the manufacturing cost and purchase cost is same, the company can either purchase from outside or can manufacture the drum Cost to Manufacture $22.00 Less: Buying from Outside $22.00 Financial Advantage/(disadvantage) of buying from outisde supplier 100000 100000 $2,200,000 $2,200,000 $0

Cost / Unit Amount Amount Ans 3 Cost of 125000 Drums Particulars Direct Cost Direct Material Direct Labor Variable Overhead $10.60 $6.40 $1.20 $1,325,000 $800,000 $150,000 $2,275,000 Add: Fixed Overhead Rent for New Equipment Supervision Total Cost $285,000 $95,000 $380,000 $2,655,000 Drum Produced $125,000 Cost/Drum [$2655000 / 125000] $21.24 Manufacturing cost/drum $21.24 Purchase Cost/drum $22.00 Since there is a saving of $ 0.76/drum on manufacturing, the Company should manufacture the drum. Cost to Manufacture $21.24 Less: Buying from Outside $22.00 Financial Advantage/(disadvantage) of buying from outisde supplier 125000 125000 $2,655,000 $2,750,000 $95,000

Working Note (i) After taking the new machinery the cost will be as under: Particulars Old Cost/unit percentage cost reduction New Cost/unit $1.20 (A) (B) [(A) x (1-(B)] Direct Material $10.60 ol $10.60 Direct Labor $8.00 20% $6.40 Variable Overhead $1.50 20% Note (ii) a General administrative overhead does not have a bearing on this decision because this expense is going to be incurred whether drum is manufactured or purchased from outside. b Depreciation is not considered as it is a sunk cost c Supervision cost is considered because this expenditure will not be required if the drum are purchased from outside.