Question

Han Products manufactures 38,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is: Direct materials $ 3.10 Direct labor 10.00 Variable manufacturing overhead 2.90 Fixed manufacturing overhead 9.00 Total cost per part $ 25.00 An outside supplier has offered to sell 38,000 units of part S-6 each year to Han Products for $19 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $88,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier. Required: What is the financial advantage (disadvantage) of accepting the outside supplier’s offer?

Answer 1

Evaluation of cost of manufacture products by itself :-

S.no.	Particulars	Amount per unit	Total cost( Amount p.u *38000)
1.	Direct Material	3.10	117800
2.	Direct Labor	10	380000
3.	Variable Manufacturing overhead	2.9	110200
4.	Fixed Manufacturing overhead(1/3)	3	114000
	Total	19	722000

Since 2/3 of fixed manufacturing overhead continue even if purchased from outside suppliers , so it is irrelevant in our decision making as it will be same in both the evaluation ,hence we would not consider such cost.

In the instant case ,if we accept offer we can avail the facilities that is used to manufacture can be rented for $88000, so it Opportunity Cost .

Hence Total Cost shall be $722000+$88000=$810000.

Evaluation of Cost in case buy from outside Supplier :-

Cost = 38000 units * $19 per unit

=$722000

Hence Financial Advantage of accepting offer = $810000-$722000

= $88000