Question

Masse Corporation uses part G18 in one of its products.

The company's Accounting Department reports the following costs of producing the 17,000 units of the part that are needed every year:

Per Unit
Direct materials $4.20
Direct labor 4.90
Variable overhead 7.90
Supervisor's salary 8.60
Depreciation of special equipment 9.20
Allocated general overhead 6.20
An outside supplier has offered to make the part and sell it to the company for $33.00 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided.
The special equipment used to make the part was purchased many years ago and has no salvage value or other use.
The allocated general overhead represents fixed costs of the entire company.
If the outside supplier's offer were accepted, only $23,000 of these allocated general overhead costs would be avoided.
In addition, the space used to produce part G18 could be used to make more of one of the company's other products, generating an additional segment margin of $32,000 per year for that product.
Required:

1. Calculate the effect on the company's total net operating income of buying part G18 from the supplier rather than continuing to make it inside the company.

2. Which alternative should the company choose?

a) Buy.
b) Make.

Answer 1

Masse Corporation:

1. Calculating the effect on the company's total net operating income of buying part G18 from supplier:

Incremental Costs to make include:

Additional segment margin - $32,000

Avoidable Overhead costs - $23,000

Direct materials ($4.20 x 17,000) = $71,400

Direct labour ($4.90 x 17,000) = $83,300

Variable overhead ($7.90 x 17,000) = $134,300

Supervisor's salary ($8.60 x 17,000) = 146,200

Total = $490,200 less purchase price = $561,000 (17,000 x $33)

= $70,800

Therefore, total net operating income would decrease by $70,800 if the company chooses to buy from the supplier.

2. The company should choose to b) Make.

Step-by-step explanation:

1. The issue to analyze here is the incremental costs of making instead of buying. These costs are avoidable. The unavoidable costs are not relevant in making decisions. They include the allocated fixed cost element that are not avoidable, including depreciation for the equipment, which had been bought in the past.

Again, past costs are not relevant in incremental analysis. Only the costs or lost benefits that will be incurred are considered.

2. It would cost the company $28.84 per unit to make the part. To buy, costs $33 per unit. Total costs to make equal $490,200. Unit cost will be $490,200 divided by 17,000 units. This equals $28.84.

Making the part will also enable the company to put the special equipment to some good use. Depreciation charge on the special equipment was not considered relevant because the associated cost was a sunk cost.