Question

Item 151 is used in one of Policy Corporation's products. The company makes 21,600 units of this item each year. The company's Accounting Department reports the following costs of producing Item 151 at this level of activity: Direct materials Direct labor Variable manufacturing overhead Supervisor's salary Depreciation of special equipment Allocated general overhead Per Unit $2.10 $3.10 $4.20 $1.90 $3.60 $9.40 An outside supplier has offered to produce Item 151 and sell it to the company for $19.40 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 item was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company. If the outside supplier's offer were accepted, only $33,200 of these allocated general overhead costs would be avoided. If management decides to buy Item 151 from the outside supplier rather than to continue making the item, what would be the annual impact on the company's overall net operating income?

Answer 1

Annual income decrease by $141,760

Offer should be rejected

Working

Differential Analysis
	Make (cost per unit x units)	Buy (21600 x 19.40)
Direct material	$       45,360.00
Direct labor	$       66,960.00
Variable Overheads + Supervisor salary	$     131,760.00
Avoidable Fixed overhead	$       33,200.00
Purchase price		$       419,040.00
Total relevant Cost	$ 277,280	$ 419,040