Question

Innova uses 1,000 units of the component IMC2 every month to manufacture one of its products. The unit costs incurred to manufacture the component are as follows. Direct materials $62.58 Direct labor 39.79 Overhead 126.50 Total $228.87 Overhead costs include variable material handling costs of $7.50, which are applied to products on the basis of direct material costs. The remainder of the overhead costs are applied on the basis of direct labor dollars and consist of 60% variable costs and 40% fixed costs. A vendor has offered to supply the IMC2 component at a price of $210 per unit. (a) Prepare the incremental analysis for the decision to make or buy IMC2.

Answer 1

Incremental Analysis is an analysis that considers the relevant costs of making a product or part vis-a-vis buying the product or part from outside.

The option to make a unit of IMC2 under incremental analysis will be:

Direct materials $62.58

Direct labour $39.79

Direct overhead:

- variable handling costs - $7.50

- 60% remainder ($126.50 - $7.50) = $71.40

Total variable cost = $181.27

This total variable cost of $181.27 per unit is then compared to the "buy" option that costs $210 per unit.

Therefore, the best option remains to make the unit in-house.

Step-by-step explanation:

Incremental analysis is a decision technique that compares the differences options in order to make a choice. It is also called by these various terms: marginal analysis, relevant cost approach, and differential analysis.

It is important to note that regardless of the option chosen, 40% of the overhead after deducting the handling cost of $7.50 from $126.50 (equals to $47.60) is a sunk cost and will still be incurred.

In incremental analysis, sunk or past costs are not regarded for decision making because they will be incurred regardless of the option.

In this example, if Innova chooses to buy in the IMC2, its total unit cost will be $257.60 (210 + 47.60).

On the other hand, if it chooses to make the IMC2 in-house, the total unit cost will still remain $228.87 (62.58 + 39.79 + 126.50).