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 $61.17
Direct labor 43.50
Overhead 126.50
Total $231.17
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 $200 per unit.
Required:
(a) Prepare the incremental analysis for the decision to make or buy IMC2.
(b) Should Innova purchase the component from the outside vendor if Innova’s capacity remains idle?

Answer 1

To decide whether to make or buy the IMC2 component, an incremental analysis compares the relevant costs of making it ($223.67 per unit including direct materials, direct labor, and variable overhead) to the offered purchase price ($200 per unit). It's financially favorable to buy the component and save $23.67 per unit unless the idle capacity can be used for other profitable means.

Step-by-step explanation:

Incremental Analysis for Make or Buy Decision

To perform the incremental analysis for the decision to make or buy the IMC2 component, we need to compare the costs associated with making the component versus the costs of buying it from the vendor. The current total cost to make one unit of IMC2 is $231.17, including direct materials, direct labor, and overhead. The overhead includes variable material handling costs which are based on direct material costs and the remaining overhead which is allocated based on direct labor dollars and is a mix of variable and fixed costs. The vendor's offer price for the IMC2 component is $200 per unit.

Cost to Make IMC2

Direct Materials: $61.17

Direct Labor: $43.50

Variable Overhead (60% of $119): $71.40

Fixed Overhead (40% of $119): $47.60

Total Cost to Make: $223.67 (Direct Materials + Direct Labor + Variable Overhead)

Cost to Buy IMC2

Price per Unit: $200

Incremental Cost Analysis

If Innova decides to buy the unit, they will save the variable costs but will still incur the fixed overhead costs that are not avoidable. Hence, the relevant costs for making the component (direct materials, direct labor, and variable overhead) amount to $223.67, while buying it would cost $200 per unit.

Decision

The decision to make or buy depends on the incremental cost savings. If Innova can purchase the component for less than it costs to make it, and there is no other use for the idle capacity that would generate revenue, then buying the component is financially favorable. Given that making the component costs $223.67 and buying costs $200, it would save $23.67 per unit to buy the component. However, if the idle capacity could be used for other profitable projects, that opportunity cost should be considered in the decision.

Answer 2

a) Increase in cost as result of buying = $(6,430)

b) Decision

Innova should make the components internally, doing so would save it $6,430.

Step-by-step explanation:

Variable material overhead = $7.50

Variable labor cost = 60%× (126.50 - 7.50 )= $71.4

Total variable overhead = 7.50 + 71.4 = $78.9

Unit variable cost = 61.17 + 43.50 + 78.9 = $193.57

Note that the balance of fixed costs were not considered because they are not relevant . This implies that they would be incurred either way.

$

Variable cost of making ($193.57× 1,000) = 193,570

Variable cost of external purchase ($200× 1,000) = 200,000

Extra variable cost of buying (6,430)

Buying the product externally would increase total cost by $(6,430)

Increase in cost as result of buying = $(6,430)

Decision

Innova should make the components internally, doing so would save it $6,430.