Question

Part U16 is used by Mcvean Corporation to make one of its products. A total of 15,500 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 $ 3.40 Direct labor $ 8.00 Variable manufacturing overhead $ 8.50 Supervisor's salary $ 3.90 Depreciation of special equipment $ 2.30 Allocated general overhead $ 7.50 An outside supplier has offered to make the part and sell it to the company for $26.70 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including the 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, none of which would be avoided if the part were purchased instead of produced internally. In addition, the space used to make part U16 could be used to make more of one of the company's other products, generating an additional segment margin of $27,500 per year for that product. The annual financial advantage (disadvantage) for the company as a result of buying part U16 from the outside supplier should be:

Answer 1

Calculation of Avoidable Cost:

Direct Materials	$3.40
Direct Labor	8.00
Variable manufacturing overhead	8.50
Supervisor's salary	3.90
Total Avoidable Cost	$23.8

Note: Depreciation is a sunk cost and not relevant for decision making.

General Fixed Overhead will remain the same irrespective of decision. Hence, not relevant for decision making.

Evaluation of offer:

Loss on Sale from outside supplier (26.70-23.8)*15,500	$(44,950)
Additional Segment Margin earned	$27,500
Financial Advantage/(Disadvantage)	$(17,450)

Hence, annual financial disadvantage for the company as a result of buying part U16 from the outside supplier = $17,450