Futura Company purchases the 80,000 starters that it installs in its standard line of farm tractors from a supplier for the price of $11.20 per unit. Due to a reduction in output, the company now has idle capacity that could be used to produce the starters rather than buying them from an outside supplier. However, the company’s chief engineer is opposed to making the starters because the production cost per unit is $12.00 as shown below:
Per Unit | Total | |||||
Direct materials | $ | 6.00 | ||||
Direct labor | 2.20 | |||||
Supervision | 1.60 | $ | 128,000 | |||
Depreciation | 1.20 | $ | 96,000 | |||
Variable manufacturing overhead | 0.50 | |||||
Rent | 0.50 | $ | 40,000 | |||
Total product cost | $ | 12.00 | ||||
If Futura decides to make the starters, a supervisor would have to be hired (at a salary of $128,000) to oversee production. However, the company has sufficient idle tools and machinery such that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The total rent on the plant is $84,000 per period. Depreciation is due to obsolescence rather than wear and tear.
Required:
What is the financial advantage (disadvantage) of making the 80,000 starters instead of buying them from an outside supplier?
Futura Company | |||||
1. Relevant cost for making | |||||
Direct Materials | 6 | ||||
Direct labour | 2.2 | ||||
Supervision | 1.6 | ||||
Variable Mfg. OH | 0.5 | ||||
Total | 10.3 | ||||
Notes:- | |||||
1. Relevant costs are those which are incurred only if the project is accepted. | |||||
If the project is not accepted, they will not incur. | |||||
2. Rent and depreciation are irrelevant as they will continue to occur | |||||
whether the products are manufactured inhouse or are purchased. | |||||
2. Relevant cost for Buying | |||||
Purchase cost | 11.2 | ||||
3. There will be a decrease in profit as the cost of purchasing is | |||||
greater than the cost of buying. | |||||
Profit would decrease by ( 11.20 - 10.3 ) * 80000 = $ 72000 per period. | |||||
FINANCIAL ADVANTAGE OF MAKING = $ 72000 |
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