Question

“In my opinion, we ought to stop making our own drums and accept that outside supplier’s offer,” said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. “At a price of $21 per drum, we would be paying $6.05 less than it costs us to manufacture the drums in our own plant. Since we use 70,000 drums a year, that would be an annual cost savings of $423,500.” Antilles Refining’s current cost to manufacture one drum is given below (based on 70,000 drums per year):

Direct materials	$	11.00
Direct labor		8.00
Variable overhead		2.00
Fixed overhead ($3.20 general company overhead, $1.95 depreciation, and $0.90 supervision)		6.05
Total cost per drum	$	27.05

A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are:

Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $189,000 per year.

Alternative 2: Purchase the drums from an outside supplier at $21 per drum.

The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 30%. The old equipment has no resale value. Supervision cost ($63,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 100,000 drums per year.

The company’s total general company overhead would be unaffected by this decision.

Required:

1. Assuming that 70,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

2. Assuming that 84,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

3. Assuming that 100,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

Answer 1

1.
Financial Advantage of Buying = $112,000

Relevant Costs
	Make	Buy	Difference
Direct Material	$     840,000		$      840,000
Direct Labor	$     392,000		$      392,000
Variable Overhead	$        98,000		$        98,000
Rent of new equipment	$     189,000		$      189,000
Supervisor	$        63,000		$        63,000
Purchase Cost		$   1,470,000	$ (1,470,000)
Total Relevant Cost	$ 1,582,000	$   1,470,000	$      112,000

2.
Financial Advantage of Buying = $84,000

Relevant Costs
	Make	Buy	Difference
Direct Material	$ 1,008,000		$   1,008,000
Direct Labor	$     470,400		$      470,400
Variable Overhead	$     117,600		$      117,600
Rent of new equipment	$     189,000		$      189,000
Supervisor	$        63,000		$        63,000
Purchase Cost		$   1,764,000	$ (1,764,000)
Total Relevant Cost	$ 1,848,000	$   1,764,000	$        84,000

3.
Financial Advantage of Buying = $52,000

Relevant Costs
	Make	Buy	Difference
Direct Material	$ 1,200,000		$   1,200,000
Direct Labor	$     560,000		$      560,000
Variable Overhead	$     140,000		$      140,000
Rent of new equipment	$     189,000		$      189,000
Supervisor	$        63,000		$        63,000
Purchase Cost		$   2,100,000	$ (2,100,000)
Total Relevant Cost	$ 2,152,000	$   2,100,000	$        52,000