Question

Futura Company purchases the 40,000 starters that it installs in its standard line of farm tractors from a supplier for the price of $8.40 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 $9.20 as shown below:

	Per Unit			Total
Direct materials	$	3.10
Direct labor		2.70
Supervision		1.50		$	60,000
Depreciation		1.00		$	40,000
Variable manufacturing overhead		0.60
Rent		0.30		$	12,000
Total product cost	$	9.20

If Futura decides to make the starters, a supervisor would have to be hired (at a salary of $60,000) 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 $80,000 per period. Depreciation is due to obsolescence rather than wear and tear.

Required:

What is the financial advantage (disadvantage) of making the 40,000 starters instead of buying them from an outside supplier?

Financial Advantage

Answer 1

Relavent costs of making the starters = Direct materials + Direct labour + Variable manufacturing overhead + Supervision

= (3.1*40,000) + (2.7*40,000) + (0.6*40,000) + 60,000

= 124,000 + 108,000 + 24,000 + 60,000

= 316,000

* Rent is irrelavent as rent charged is based on space utilized in the plant.

* Depreciation is irrelavent as Depreciation is due to obsolescence.

Relavent cost of buying the starters = 40,000 * 8.4 = 336,000

Financial advantage of making the 40,000 starters instead of buying them from an outside supplier

= 336,000 - 316,000

= 20,000