Question

Cane Company manufactures two products called Alpha and Beta that sell for $135 and $95, respectively. Each product uses only one type of raw material that costs $6 per pound. The company has the capacity to annually produce 105,000 units of each product. Its average cost per unit for each product at this level of activity are given below:

	Alpha				Beta
Direct materials		$	30			$	18
Direct labor			23				16
Variable manufacturing overhead			10				8
Traceable fixed manufacturing overhead			19				21
Variable selling expenses			15				11
Common fixed expenses			18				13
Total cost per unit		$	115			$	87

The company considers its traceable fixed manufacturing overhead to be avoidable, whereas its common fixed expenses are unavoidable and have been allocated to products based on sales dollars.

9. Assume that Cane expects to produce and sell 83,000 Alphas during the current year. A supplier has offered to manufacture and deliver 83,000 Alphas to Cane for a price of $92 per unit. What is the financial advantage (disadvantage) of buying 83,000 units from the supplier instead of making those units?

10. Assume that Cane expects to produce and sell 53,000 Alphas during the current year. A supplier has offered to manufacture and deliver 53,000 Alphas to Cane for a price of $92 per unit. What is the financial advantage (disadvantage) of buying 53,000 units from the supplier instead of making those units?

Answer 1

Solution 1:

Since there is a decision to be taken whether to manufacture Alphas in-house or it should be outsourced and bought from outside.

For In-house production, let’s find out the relevant cost of Alphas:

• Direct Material cost of $30, direct labor cost of $23 and variable overhead of $10 per unit are relevant costs since it will be incurred for production of every carburetor.
• Traceable fixed overhead of $19 per unit is avoidable which means had company chose not to produce Alphas inhouse, this cost would not be incurred. Hence $19 is also a relevant cost. But it is to be noted that $19 of unit cost is at activity level of 105,000 units, hence total fixed overhead of $1,995,000 (105,000 * $19). Hence for 83,000 Units, Relevant cost would be $1,995,000 / 83,000 = $24.04
• Allocated common fixed expenses are sunk cost hence irrelevant cost. This cost will continue to happen whether if it is producedin house or bought from outside. Hence $18 of allocated fixed overhead is irrelevant cost.
• Variable Selling expenses will continue to be incurred. Since this is selling related expense, it need not be considered as cost of production.

Total relevant cost for production is $30 + $23+ $10 + $24.04 = $87.04 per unit

Vendor quoted price is $92 per unit. Hence if bought outside, it will create a disadvantage of $4.96 per unit for every Alphas bought.

For 83,000 Alphas, Financial disadvantage = $4.96 * 83,000 = $411,680

Solution 2:

Traceable fixed overhead of $19 per unit is avoidable which means had company chose not to produce Alphas in-house, this cost would not be incurred. Hence $19 is also a relevant cost. But it is to be noted that $19 of unit cost is at activity level of 105,000 units, hence total fixed overhead of $1,995,000 (105,000 * $19). Hence for 53,000 Units, Relevant cost would be $1,995,000 / 53,000 = $37.64

Total relevant cost for production is $30 + $23+ $10 + $37.64 = $100.64 per unit

Vendor quoted price is $92 per unit. Hence if bought outside, it will create an advantage of $8.64 per unit for every Alphas bought.

For 53,000 Alphas, Financial advantage = $8.64 * 53,000 = $457,920

Assumption: We have been assuming that Freed up capacity derived from purchase of Alphas from outside vendor would not result in additional margin since there is no information given in question.

Please feel free to comment if the concept is unclear, happy to help. As always, keep studying, grind hard