Question

Penagos Corporation is presently making part Z43 that is used in one of its products. A total of 5,000 units of this part are produced and used every year. The company's Accounting Department reports the following costs of producing the part at this level of activity:

	Per Unit
Direct materials	$	1.10
Direct labor	$	3.10
Variable overhead	$	6.90
Supervisor's salary	$	5.80
Depreciation of special equipment	$	5.20
Allocated general overhead	$	5.60

An outside supplier has offered to produce and sell the part to the company for $20.80 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company. If the outside supplier's offer were accepted, only $4,000 of these allocated general overhead costs would be avoided.

If management decides to buy part Z43 from the outside supplier rather than to continue making the part, what would be the annual financial advantage (disadvantage)?

Answer 1

Solution:

Differential Analysis - Making (alt 1) or buying (Alt2) Mountain Air
Particulars	Making(Alt 1)	Buying (Alt 2)	Financial advantage (Disadvantage) of buying (Alternative 2)
Costs:
Purchase Price (5000*$20.80)	$0.00	$104,000.00	-$104,000.00
Direct material (5000*$1.10)	$5,500.00	$0.00	$5,500.00
Direct Labor (5000*$3.10)	$15,500.00	$0.00	$15,500.00
Variable overhead (5000*$6.90)	$34,500.00	$0.00	$34,500.00
Supervisor's Salary (5000*$5.80)	$29,000.00	$0.00	$29,000.00
Avoidable General Overhead	$4,000.00	$0.00	$4,000.00
Total Cost	$88,500.00	$104,000.00	-$15,500.00

If we buy part Z43 from outside supplier rather than to continue making the part, there will be financial disadvantage of $15,500 because cost will increase by $15,500.