Question

Diehl Corporation manufactures a variety of parts for use in its product. The company has always produced all of the necessary parts for its product, including all of the electronic circuits. The company sells 20,000 units of its product per year. An outside supplier has offered to sell electronic circuits to the company for a cost of $36 per unit. To evaluate this offer, the company has gathered the following information relating to its own cost of producing the electronic circuits internally:

	Per Unit				20,000 Units per Year
Direct materials	$	17		$	340,000
Direct labor		10			200,000
Variable manufacturing overhead		2			40,000
Fixed manufacturing overhead, traceable		9	*		180,000
Fixed manufacturing overhead, allocated		12			240,000
Total cost	$	50		$	1,000,000

*One-third supervisory salary; two-thirds depreciation of special equipment (no resale value).

Suppose that if the electronic circuits were purchased, the division supervisor position could be eliminated. Fixed manufacturing overhead will be allocated to other products made by the company. Also, the company could use the freed production capacity to launch a new product. The segment margin of the new product would be $200,000 per year. Given this new assumption, how much would be the financial advantage of buying 20,000 electronic circuits from the outside supplier?

Multiple Choice

• A $140,000

• B $120,000

• C $280,000

• D $60,000

Answer 1

In order to calculate financial advantage we would first calculate total cost under both alternatives.

Alternative 1: If produced inhouse

Direct Material	$17
Direct Labor	$10
Variable manufacturing overhead	$2
Fixed overhead	$9
Total cost	$38
Total Cost for 20,000 units (20,000 * 38)	$760,000

Allocated fixed cost are irrelevant as they can be allocated to other product as well.

Alternative 2 : If product is purchased from outside supplier.

Cost of purchasing	$36
Add: Supervisor salary (2/3rd of $9)	$6
Total cost per unit	$42
Total cost for 20,000 units	$840,000
Less: Segment margin for new product	$200,000
Total Cost	$640,000

​​​​​Thus, we can see that there is cost saving of $120,000 ($760,000 - $640,000). Therefore Option B is correct answer.