Question

Futura Company purchases the 62,000 starters that it installs in its standard line of farm tractors from a supplier for the price of $12.10 per unit. Due to a reduction in output, the company now has idle capacity that could be used to produce the starters rather than buying them from an outside supplier. However, the company’s chief engineer is opposed to making the starters because the production cost per unit is $13.20 as shown below:

	Per Unit			Total
Direct materials	$	6.00
Direct labor		3.20
Supervision		1.80		$	111,600
Depreciation		1.30		$	80,600
Variable manufacturing overhead		0.40
Rent		0.50		$	31,000
Total product cost	$	13.20

If Futura decides to make the starters, a supervisor would have to be hired (at a salary of $111,600) to oversee production. However, the company has sufficient idle tools and machinery such that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The total rent on the plant is $90,000 per period. Depreciation is due to obsolescence rather than wear and tear.

Required:

What is the financial advantage (disadvantage) of making the 62,000 starters instead of buying them from an outside supplier?

Answer 1

Particulars	Result
Relevant Costs	Those that can be avoided or eliminated by external purchases
Irrelevant Costs	Those unavoidable costs that will not change regardless of whether the firm makes or buy the item

Relevant Costs
All The Variable Costs	Other Costs
Direct Material	Supervision Cost
Direct Labour
Variable Manufacturing Overhead

Irrelevant Costs

Depreciation

Rent

Relevant Cost Per Unit
Particulars	Amount ($)
Direct Material	6
Direct Labour	3.2
Supervision	1.8
Variable Manufacturing Overhead	0.4
Total	11.4

The financial advantage of making the 62,000 starters instead of buying them from an outside supplier

= ($12.1 - $11.4) * 62,000 Starters.

= $43,400.