Question

Han Products manufactures 31,000 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 $ 3.50

Direct labor 8.00

Variable manufacturing overhead 2.50

Fixed manufacturing overhead 6.00

Total cost per part $ 20.00

An outside supplier has offered to sell 31,000 units of part S-6 each year to Han Products for $18 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 $81,000. 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

Relevant variable costs pe runit = Direct materials per unit + Direct labour per unit + Variable manufactuting overhead per unit + (Fixed manufacturing overhead cost per unit * 1/3)

= $3.5 + $8 + 2.5 + ($6*1/3)

= $16

Total relevant costs = Variable costs + Opportunity cost of the lost rent

= (31,000 * $16) + $81,000

= $496,000 + $81,000

= $577,000

Total relevent costs to buy = 31,000 units * $18 per unit

= $558,000

Financial advantage of accepting the outside supplier’s offer = $577,000 - $558,000

= $19,000