Question

Vernon Chemical Company makes a variety of cosmetic products, one of which is a skin cream designed to reduce the signs of aging. Vernon produces a relatively small amount (18,000 units) of the cream and is considering the purchase of the product from an outside supplier for $5.90 each. If Vernon purchases from the outside supplier, it would continue to sell and distribute the cream under its own brand name. Vernon's accountant constructed the following profitability analysis: Revenue (18,000 units X $15.00) Unit-level materials costs (18,000 units * $1.90) Unit-level labor costs (18,000 units * $0.50) Unit-level overhead costs (18,000 x $0.40) Unit-level selling expenses (18,000 * $0.20) Contribution margin Skin cream production supervisor's salary Allocated portion of facility-level costs Product-level advertising cost Contribution to company-wide income $270,000 (34,200) (9,000) (7,200) (3.600) 216,000 (66,000) (13,100) 48,000) $ 88,900 Required a. Identify the cost items relevant to the make-or-outsource decision. b. What is the avoidable cost per unit if the outsourcing decision is taken? Should Vernon continue to make the product or buy it from the supplier? c. Suppose that Vernon is able to increase sales by 11,000 units (sales will increase to 29,000 units). Calculate the total avoidable costs. At this level of production, should Vernon make or buy the cream?

Answer 1

a) Cost Items Relevant:

Particulars	Amount ($)
Unit-level material costs (18,000 * $1.90)	34,200
Unit-level labour costs (18,000 * $0.50)	9,000
Unit-level overhead costs (18,000 * $0.40)	7,200
Unit-level selling expenses (18,000 * $0.20)	3,600
Skin cream production supervisor’s salary	66,000
Total	120,000

b) Avoidable cost per unit = Cost Item Relevant(calculated in point 1)/total units

=   $120,000/ 18,000 = $6.67/ unit

After considering the unit cost of making cream ($6.67) and outsourcing/ buy the cream ($5.90), it is profitable for the Vernon Chemical Company to outsource the production/ buy of cream. It will help the company save $0.77 per unit.

c) Total Avoidable Cost:

Particulars	Amount ($)
Unit-level material costs (29,000 * $1.90)	55,100
Unit-level labour costs (29,000 * $0.50)	14,500
Unit-level overhead costs (29,000 * $0.40)	11,600
Unit-level selling expenses (29,000 * $0.20)	5,800
Skin cream production supervisor’s salary	66,000
Total	153,000

Avoidable cost per unit = Cost Item Relevant /total units

=   $153,000/ 29,000 = $5.28/ unit

After considering the unit cost of making cream ($5.28) and outsourcing/ buy the cream ($5.90), it is profitable for the Vernon Chemical Company to do production of cream/ make the cream. It will help the company save $0.62 per unit.