Question

Note that data typically changes for each new question, even when the same company or product name is used.

Cool Clothing, Inc. currently manufactures shirts. The company is interested in outsourcing production to a reputable manufacturing company that can supply the shirts for $10 per unit. Cool Clothing produces 20,000 shirts each year. Variable production costs are $4 per unit and annual fixed costs total $170,000. If production is outsourced, all variable costs and 60 percent of annual fixed costs will be eliminated.

Which is the best alternative, producing internally or outsourcing?

a) Outsourcing is the best option and results in $68,000 in savings compared to internal production.

b) Producing the shirts internally is the best option and results in $68,000 in savings compared to outsourcing production.

c) Producing the shirts internally is the best option and results in $18,000 in savings compared to outsourcing production.

d) Outsourcing is the best option and results in $18,000 in savings compared to internal production.

Answer 1

Unavoidable fixed cost is sunk cost. Hence, 40% of the annual fixed cost is sunk and hence, irrelevant for decision making between outsourcing or producing internally.
Now, calculation for relevant cost if the product is internally produced will be done as follows:
Particulars	Amount
Variable cost (20,000 shirts x $4 per unit)	$80,000
Add: Avoidable Annual fixed cost ($170,000 x 60%)	$1,02,000
Relevant cost of producing internally	$1,82,000
Now, the relevant cost of outsourcing is $200,000 (20,000 shirts x $10 per shirt)
Hence, we can conclude that internally producing the shirts is more beneficial as it results in savings of $18,000 ($200,000 - $182,000)
Hence, option c is the correct answer