Question

Han Products manufactures 30,000 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 . . . . . . . . . . . . . . . . . . . . . $ 3.60

Direct labor . . . . . . . . . . . . . . . . . . . . . . . .   10.00

Variable manufacturing overhead . . . . . . . 2.40

Fixed manufacturing overhead . . . . . . . . . 9.00

Total cost per part . . . . . . . . . . . . . . . . .   $ 25.00

An outside supplier has offered to sell 30,000 units of part S- 6 each year to Han Products for $ 21 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 $ 80,000. 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:

Prepare computations showing how much profits will increase or decrease if the outside supplier’s offer is accepted.

Answer 1

(i) Total cost in the scenario if we parts of S-6 produce ourself
	Amt. $
Total cost per part (A)	25
Total Units (B)	30000
Total Cost (A*B)	750000
(ii) Total cost in the scenario if we purchase part of S-6 from outside
	Amt. $
(A) Total cost per part offered by outsider	21
(B) Total Units	30000
(C) Total Cost of Purchase (A*B)	630000
(D) Add : Unavoidable fixed cost of existing facility (2/3*9*30000)	180000
(E) Less : Annual rent income if we let out existing plant	-80000
Net Total Cost (C+D+E)	730000
Thus,
Net increase in profit (i.e. Decrease in purchase cost) if we purchase from outside = 750000-730000 = 20,000