Question

Pharoah Company purchases sails and produces sailboats. It currently produces 1,300 sailboats per year, operating at normal capacity, which is about 80% of full capacity. Pharoah purchases sails at $261 each, but the company is considering using the excess capacity to manufacture the sails instead. The manufacturing cost per sail would be $90 for direct materials, $88 for direct labor, and $90 for total manufacturing overhead. The $90 total manufacturing overhead includes $78,000 of annual fixed overhead that is allocated using normal capacity.

The president of Pharoah has come to you for advice. "It would cost me $268 to make the sails," she says, "but only $261 to buy them. Should I continue buying them, or have I missed something?"

Answer 1

The president of Pharoah Company should consider manufacturing sails in-house by looking at variable costs and the potential for economies of scale, rather than simply comparing the apparent total production cost to the purchase price. The fixed overhead is a sunk cost, and it's the variable costs that should be taken into account for this marginal decision.

Step-by-step explanation:

The president of Pharoah Company purchases sails for their sailboats and is considering whether to continue buying them at $261 each or to start producing them in-house for a total cost of $268 per sail. This in-house cost includes $88 for direct labor, and $90 for total manufacturing overhead, within which $78,000 is fixed overhead allocated using normal capacity. However, it's important to note that by utilizing excess capacity to manufacture sails, the variable costs of $178 ($90 for direct materials and $88 for direct labor) should be considered, as the fixed overhead would exist irrespective of the decision to manufacture or purchase sails. This situation relates to the concept of economies of scale, where increasing production can result in lower average costs per unit. In the case provided, the fixed costs become less significant as they are spread over more units.

Given that Pharoah Company is operating at only 80% of capacity, the potential to increase production and achieve economies of scale could be realized by manufacturing sails in-house, provided the increase in units produced lowers the average fixed cost per sail. If considering only variable costs, it would cost the company less to produce the sails in-house than to purchase them. Therefore, when assessing whether she I missed something? in her analysis, the president should look at the entire cost structure and not just the apparent total cost per sail.