Question

Your Corporation is presently making a part that is used in one of its products. A total of 8,000 units of this part are produced and used every year. The company's Accounting has the following costs of producing the part at this level of activity:

Direct materials.                              $3.70

Direct labor                                      $1.00

Variable overhead                            $6.90

Supervisors salary                           $8.80

Depreciation of special equipment. $3.30

Allocated general overhead.           $1.60

An outside supplier has offered to produce and sell the part to the company for $24.50 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company, none of which would be avoided if the part were purchased instead of produced internally. If management decides to buy the part from the outside supplier rather than to continue making the part, what would be the annual change in net operating income?

Answer 1

	Make	Buy	Differential Effect on Income
Direct material	8,000 x 3.70 = 29,600	0	29,600
Direct labor	8,000 x 1 = 8,000	0	8,000
Variable overhead	8,000 x 6.90 = 55,200	0	55,200
Supervisors salary	8,000 x 8.80 = 70,400	0	70,400
Depreciation of special equipment	8,000 x 3.30 = 26,400	8,000 x 3.30 = 26,400	0
Allocated general overhead	8,000 x 1.60 = 12,800	8,000 x 1.60 = 12,800	0
Outside supplies price	0	8,000 x 24.50 = 196,000	-196,000
Total cost	$202,400	$235,200	-$32,800

Net operating income would decrease by $32,800, if the part is bought from the outside suppliers.

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