Question

Make or Buy a Component [LO2]

Royal Company manufactures 10,000 units of Part R-3 each year. At this level of activity, the cost per unit for Part R-3 follows

Direct materials	$14.40
Direct labour	21.00
Variable manufacturing overhead	9.60
Fixed manufacturing overhead	25.00
Total cost per part	$70.00

An outside supplier has offered to sell 10,000 units of Part R-3 each year to Royal Company for $54 per part. However, Royal Company has determined that $15 of the fixed manufacturing overhead being applied to Part R-3 would continue even if the part were purchased from the outside supplier.

Required:

Part 1: Prepare computations showing how much profits will increase or decrease if the outside supplier’s offer is accepted. (7 Marks)

Part 2: Now assume if Royal Company accepts this offer, the facilities now being used to manufacture Part R-3 could be rented to another company at an annual rental of $150,000. Prepare computations showing how much profits will increase or decrease if the outside supplier’s offer is accepted. (5 Marks)

Answer 1

Solution 1:

Differential Analysis- Royal Company - Making Part R-3 (alt 1) or Buying Part R-3 (Alt2)
Particulars	Making Part R-3 (Alt 1)	Buying Part R-3 (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (10000*$54)	$0.00	$540,000.00	-$540,000.00
Direct material	$144,000.00	$0.00	$144,000.00
Direct Labor	$210,000.00	$0.00	$210,000.00
Variable overhead	$96,000.00	$0.00	$96,000.00
Avoidable Fixed Overhead	$100,000.00	$0.00	$100,000.00
Total Cost	$550,000.00	$540,000.00	$10,000.00

Solution 2:

Differential Analysis- Royal Company - Making Part R-3 (alt 1) or Buying Part R-3 (Alt2)
Particulars	Making Part R-3 (Alt 1)	Buying Part R-3 (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (10000*$54)	$0.00	$540,000.00	-$540,000.00
Direct material	$144,000.00	$0.00	$144,000.00
Direct Labor	$210,000.00	$0.00	$210,000.00
Variable overhead	$96,000.00	$0.00	$96,000.00
Avoidable Fixed Overhead	$100,000.00	$0.00	$100,000.00
Opportunity cost	$150,000.00	$0.00	$150,000.00
Total Cost	$700,000.00	$540,000.00	$160,000.00