Question

Royal Company manufactures 20,000 units of part R-3 each year for use on its production line. At this level of activity, the cost per unit for part R-3 is:

Direct Materials ……………………... $ 4.80

Direct labor ………………………………… 7.00

Variable manufacturing overhead ………….. 3.20

Fixed Manufacturing Overhead ……………… 10.00

Total cost per part…………………………….. $25.00

An outside supplier has offered to sell 20,000 units of part R-3 each year to Royal Company for $23.50 per part. 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. However, Royal Company has determined that $6 of the fixed manufacturing overhead being applied to part R-3 would continue even if part R-3 were purchased from the outside supplier.

Required:

Prepare computations showing how much profits will increase or decrease if the outside supplier's offer is accepted.

Answer 1

The profit will increase by $ 60000 if outside supplier offer is accepted.

Incremental savings if purchased
Direct material (4.8*20000)	96000
Direct labor (7*20000)	140000
Variable overhead (3.2*20000)	64000
Fixed overhead (4*20000)	80000
Rental income	150000
Total savings		530000
Incremental cost if purchased
Purchase cost (20000*23.50)		(470000)
Advantage /(disadvantage) if purchased		60000

#Out of fixed overhead ,$ 6 will be incurred even if purchased thus saving in fixed cost per unit if purchased = 10 -6 = $ 4