Question

United Co manufactures part X12 used in several of its truck models. 1,000 units are produced each year with production costs as follows: Direct materials $ 70,000 Direct manufacturing labor 50,000 Variable support costs 40,000 Fixed support costs 80,000 Total costs $240.000 The company has the option of purchasing part X12 from an outside supplier at $200 per unit. If X12 is outsourced, 30% of the fixed costs cannot be immediately converted to other us Required: a. Describe avoidable costs What amount of the X12 production costs is avoidable? Should the company outsource X12? Why or why not? What other items should the company consider before outsourcing any of the parts it currently manufactures?

Answer 1

Solution :

Part A :

Avoidable costs are those costs associated with a particular activity, which will be avoided when the activity is not performed.

In this given case, the activity is identified as "Manufacturing X12". When the manufacturing is not performed by the company, and is outsourced to third party, the costs associated with manufacturing can be avoided. Since, the avoidable costs influence the decision - as to whether the company should manufacture the product X12 or outsource it, these costs are also called "relevant cost".

Amount of production cost avoidable :

= Direct Material + Direct manufacturing labor + Direct variable support cost + Fixed costs avoided

= $70,000 + $50,000 + $40,000 + 70% of $80,000*

= $216,000

*It is given the question that 30% of the Fixed cost cannot be immediately converted to other use. Which indicates that the 30% fixed cost will be still incurred even if the manufacturing is not carried out. It has been assumed that the 70% of the fixed costs are specific fixed costs related to the manufacturing and do not have other use  hence are completely avoided.

However, an alternative assumption is possible that the 70% of the fixed costs are not specific fixed costs and they have been put to alternative use, which means these costs are not avoidable. In such case, even the 70% fixed cost will not be included in the above calculations.

PART B :

Cost incurred when the production process is not carried out by the company & is outsourced to the third party :

= $200 p.u x 1,000 units

= $200,000

Comparing outsourcing cost vs manufacturing cost option

Cost saved when the company does not carry out manufacturing = $216,000

Less : Costs paid to third party supplier on outsourcing production of X12 = $200,000

Net Savings on Outsourcing = $16,000

Since, the outsourcing option is resulting in a savings of $16,000 to the company. The production of product X12 should be outsourced to the third party supplier.

PART C :

The following are the items that are to be considered while outsourcing the contract to the third party supplier :

1) Reputation of the supplier.

2) Quality of the input used and the output produced by the supplier.

3) Whether timely delivery will be made by the supplier.

4) Evaluation as the whether the relationship with the supplier will be on a long term basis.

5) Evaluating whether there is any possible rise in outsourcing costs in the upcoming months or whether any other additional costs has to be borne by the company.

Note : If you have any queries relating to this answer, do reach us out at the comment section below. Your valuable feedback is important to us.