Question

Rainy Day Company Corporation manufactures umbrellas. The company currently makes the handles for the umbrellas, however, they have been approached by an outside supplier for to purchase the handles from them at a cost of $4.00. Management is trying to determine which is more cost effective and have provided some information for you to analyze:

	Per Unit	Total
Direct Materials	$3.50
Direct Labour	$3.00
Production supervisor	$4.00	$80,000
Depreciation	$1.00	$20,000
Rent	$0.25	$5,000

The production supervisor will be employed in the factory whether the company buys or makes the handlebars. The depreciation is incurred on the factory equipment and is based on obsolescence (rather than wear and tear). Rent is on the entire production factory. The company will keep the same size of factory, even if they decide to purchase the handlebars from a supplier.

Required:

a. What is the cost if the company makes the handles
b. Should the company make the handles or purchase from an outside supplier?

Answer 1

a) Cost to the company if they make handles = $6.5 per unit i.e. Direct Material + Direct labour.

The production supervisor will be employed in the factory whether the company buys or makes the handlebars and so as rent , depreciation is also absorbed cost and which means they all are irrelevant cost for the determination of decision making

b) The company should purchase the order from outside supplier because it will save $ 2.5 per unit ( $6.5 - $4) as all other cost will remain same whether we purchase from outside or manufacture.