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 $21 per drum, we would be paying $7.05 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 $458,250.” Antilles Refining’s current cost to manufacture one drum is given below (based on 65,000 drums per year):

Direct materials	$	10.70
Direct labor		9.50
Variable overhead		1.50
Fixed overhead ($3.50 general company overhead, $1.95 depreciation, and $0.90 supervision)		6.35
Total cost per drum	$	28.05

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 $175,500 per year.

Alternative 2: Purchase the drums from an outside supplier at $21 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 30%. The old equipment has no resale value. Supervision cost ($58,500 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 130,000 drums per year.

The company’s total general company overhead would be unaffected by this decision.

Required:

1. Assuming that 65,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 90,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 130,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

	Production Needs		Financial advantage or (disadvantage)
1	65000	drums	65000
2	90000	drums	0
3	130000	drums

Answer 1

1.

	Make	Buy	Financial advantage/disadvantage
Direct material@$10.70	$695,500	0	$695,500
Direct [email protected] (9.50*70%)	432,250	0	432,250
Variable [email protected] (1.50*70%)	68,250	0	68,250
[email protected]	58,500	0	58,500
Rent on new equipment	175,500	0	175,500
Purchase price(65,000*$21)	0	$1,365,000	(1,365,000)
Total	$1,430,000	$1,365,000	$65,000

2.

	Make	Buy	Financial advantage/disadvantage
Direct material@$10.70	$963,000	0	$963,000
Direct [email protected] (9.50*70%)	598,500	0	598,500
Variable [email protected] (1.50*70%)	94,500	0	94,500
Supervision	58,500	0	58,500
Rent on new equipment	175,500	0	175,500
Purchase price(90,000*$21)	0	$1,890,000	(1,890,000)
Total	$1,890,000	$1,890,000	$0

3.

	Make	Buy	Financial advantage/disadvantage
Direct material@$10.70	$1,391,000	0	$1,391,000
Direct [email protected] (9.50*70%)	864,500	0	864,500
Variable [email protected] (1.50*70%)	136,500	0	136,500
[email protected]	58,500	0	58,500
Rent on new equipment	175,500	0	175,500
Purchase price(130,000*$21)	0	2,730,000	(2,730,000)
Total	$2,626,000	$2,730,000	$(104,000)