Question

Mohave Corp. is considering outsourcing production of the umbrella tote bag included with some of its products. The company has received a bid from a supplier in Vietnam to produce 9,600 units per year for $7.00 each. Mohave has the following information about the cost of producing tote bags:        

Direct materials	$	3
Direct labor		2
Variable manufacturing overhead		1
Fixed manufacturing overhead		2.50
Total cost per unit	$	8.50

Mohave has determined that all variable costs could be eliminated by outsourcing the tote bags, while 75 percent of the fixed overhead cost is unavoidable. At this time, Mohave has no specific use in mind for the space currently dedicated to producing the tote bags.

Required:
1. Compute the difference in cost between making and buying the umbrella tote bag.



2. Should Mohave buy the tote bags or continue to make them?

	Buy
	Make

3-a. Suppose that the space Mohave currently uses to make the bags could be utilized by a new product line that would generate $6,000 in annual profits. Recompute the difference in cost between making and buying the umbrella tote bag.



3-b. Does this change your recommendation to Mohave?

	No
	Yes

Answer 1

1. Cost of buying = $7

Cost of producing = 3+2+1+(2.5*25%) = 6+.625 = $6.625

Hence savings in making = 7-6.625= $.375 per unit

Total savings = .375*9600 = $3600

Unavoidable fixed costs have not been considered since it is sunk cost.

2. Since cost of producing is less than cost of buying, it should continue to make the products.

3.a Relevant cost of making = 9200*6.625 =$60950

Add: Profits lost from blocked space = $6000

Total relevant costs = $66950

Cost per unit = 66950/9200 = $7.277

Cost of buying per unit =$7

Difference = $.277 per unit

Total difference = 9200*.277 =$2550

b. Yes this changes the recommendation to Mohave now since the cost of buying is lower than the relevant cost of production it should now purchase.

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