Question

A company produces 200 microwave ovens per​ month, each of which includes one electrical circuit. The company currently manufactures the circuits​ in-house but is considering outsourcing the circuits at a contract cost of​ $28 each.​ Currently, the cost of producing circuits​ in-house includes variable costs of​ $24 per circuit and fixed costs of​ $5,000 per month. Assume the company could eliminate all fixed costs by outsourcing and that there is no alternative use for the facilities presently being used to make circuits. If the company​ outsources, operating income will​ ________

Answer 1

Answer: Increase by a saving of $4,200

Explanation: In order to calculate the change in operating income we need to look at the relevant costs affecting this calculation. Relevant costs are costs that are affected due to a change in a decision. The decision the company is facing is whether to outsource the circuits or to continue producing them in - house. The company will only change to outsourcing if it costs less, resulting in the company saving cash.

The costs of producing the circuits in - house are as follows:

Variable costs: $24 x 200 = $4800

Fixed costs: = $5000

Total costs: = $9800

If the company decides to outsource, then there will be no variable costs, as these costs are incurred per circuit produced. It is also indicated that fixed costs will be completely eliminated if outsourcing is done. Both these costs are thus relevant costs, as they will be affected if the alternative decision to outsource is chosen.

If outsourcing is chosen then:

Total contract costs: $28 x 200 = $5600

∴ If the company outsources then they will incur a saving of: 9800 (in - house cost) - 5600 (contract cost) = $4200. This will increase the company's operating income.