Question

Make or buy, qualitative factors (CMA adapted)  

The Vernom Corporation produces and sells to wholesalers a highly successful line of summer lotion and insect repellents. Vernom has decided to diversify to stabilize sales throughout the year. A natural area for the company to consider is the production of winter lotions and creams to prevent dry and chapped skin.
After considerable research, a winter products line has been developed. However, because of the conservative nature of company management, Vernom’s president has decided to introduce only one of the new products for this coming winter. If the product is a success, further expansion in future years will be initiated.
The product selected is a lip balm to be sold in a lipstick-type tube. The product will be sold to wholesalers in boxes of 24 tubes for $18.00 per box. Because of available capacity, no additional fixed charges will be incurred to produce the product. However, a $200,000 fixed charge will be assigned to allocate a fair share of the company’s fixed costs to the new product. The remaining overhead costs are variable.
Using estimated sales and production of 100,000 boxes of lip balm as the standard volume, the accounting department has developed the following costs per box of 24 tubes.
Direct labor Direct materials Total overhead Total
$ 4.00 6.00 3.00 $13.00
Vernom approached a cosmetics manufacturer to discuss the possibility of purchasing the tubes for the new product. The purchase price of the empty tubes from the cosmetics manufacturer would be $1.80 per 24 tubes. If Vernom accepts the purchase proposal, it is estimated that direct labor and variable overhead costs would be reduced by 10% and direct materials costs would be reduced by 20%.
A. Should the Vernom Corporation make or buy the tubes? Show calculations to support your answer.

B. What would be the maximum purchase price acceptable to Vernom for the tubes? Explain.

C. Instead of sales of 100,000 boxes, revised estimates show sales volume at 125,000 boxes.At this new volume, additional equipment at an annual rental of $20,000 must be acquired to manufacture the tubes. However, this incremental cost would be the only additional fixed cost required, even if sales increased to 300,000 boxes. (The 300,000 level is the goal for the third year of production.) Under these circumstances, should Vernom make or buy the tubes? Show calculations to support your answer.

Answer 1

A. Vernom Corporation should make the tubes.

Fixed overhead cost per unit = $ 200,000 / 100,000 = $ 2.00

Variable overhead cost per unit = $ 3.00 - $ 2.00 = $ 1.00.

Total cost of making the tubes per unit = $ 6.00 x 20 % + $ ( 4.00 + 1.00 ) x 10 % = $ 1.70

Purchase cost per unit = $ 1.80

Since cost of making < the cost of buying, Vernom should continue to make the unit.

B. The maximum purchase price acceptable to Vernom would be $ 1.70.

$ 1.70 represents the total cost that can be avoided per unit if Vernom outsources the tubes. Vernom would not be willing to pay anything in excess the cost that it saves.

C. Vernom should buy the tubes.

Cost to buy the tubes at a sales level of 125,000 boxes = 125,000 x $ 1.80 = $ 225,000.

Cost to make the tubes at a sales level of 125,000 boxes = 125,000 x $ 1.70 + $ 20,000 = $ 232,500

As the cost of making exceeds the cost of buying, Vernom should buy the tubes.