98) Assume that a company manufactures numerous component parts, one of which is called Part A. The company’s absorption costing system indicates that it costs $23.00 to make one unit of Part A as shown below:
|Total absorption cost per unit||$||23.00|
The company is trying to decide between two alternatives:
Alternative 1: Continue making 80,000 units of Part A per year using its existing equipment at the unit cost shown above. The equipment used to make this part does not wear out through use and it has no resale value.
Alternative 2: Replace the existing equipment with a new piece of equipment that the company would rent for $152,000 per year. The new piece of equipment would be used to make 80,000 units per year and it would reduce Part A’s direct labor cost per unit by 20% and its variable overhead per unit by 30%. The direct materials cost per unit will remain constant.
What is the financial advantage or (disadvantage) of renting the new piece of equipment?
For calculating financial advantage or disadvantage of renting the new piece of equipment following steps need to be followed
Total absorption cost is given = $23.00 if we choose alternative 1, but for alternative 2 we need to find its cost so for it following steps are followed-
Direct materials =. $10.00
Direct labor(less 20%)
(6-1.2) =. $4.8
Variable overhead (less 30%)
(2*30%) = $1.4
(2-1.4) =. $1.6
Fixed overhead =. $5
Total cost. =. $21.20
Now, total manufacturing cost in alternative 1 = 80000* $23.00 = $1840000
(Less) manufacturing cost in alternative 2 = 80000*$21.20 =$1696000
Financial advantage before deduction of rent for the new piece of equipment = $144000
(Less) Rent for new piece of equipment= $152000
Then financial disadvantage= ($8000)
So option (2) is correct.
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