Question

Futura Company purchases the 60,000 starters that it installs in its standard line of farm tractors from a supplier for the price of $11.50 per unit. Due to a reduction in output, the company now has idle capacity that could be used to produce the starters rather than buying them from an outside supplier. However, the company’s chief engineer is opposed to making the starters because the production cost per unit is $11.60 as shown below:

	Per Unit			Total
Direct materials	$	5.00
Direct labor		2.80
Supervision		1.60		$	96,000
Depreciation		1.00		$	60,000
Variable manufacturing overhead		0.70
Rent		0.50		$	30,000
Total production cost	$	11.60

If Futura decides to make the starters, a supervisor would have to be hired (at a salary of $96,000) to oversee production. However, the company has sufficient idle tools and machinery such that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The total rent on the plant is $90,000 per period. Depreciation is due to obsolescence rather than wear and tear.

Required:

What is the financial advantage (disadvantage) of making the 60,000 starters instead of buying them from an outside supplier?

Answer 1

Financial advantage can be computed as:

Financial advantage=Cost of purchase-Cost of production

Cost of purchase=Number of starters*price per starter

Cost of purchase=60,000*$11.50

Cost of purchase=$690,000

Cost of production=Number of units*(Material+Labor+Variable overhead+Supervision)

Cost of production=60,000*($5.00+$2.80+$0.70+$1.60)

Cost of production=60,000*($10.1)

Cost of production=$606,000

Financial advantage=$690,000-$606,000

Financial advantage=$84,000

The financial advantage of making rather than buying is $84,000.