Question

Kerbow Corporation uses part B76 in one of its products. The company's Accounting Department reports the following costs of producing the 12,000 units of the part that are needed every year. An outside supplier has offered to make the part and sell it to the company for $27.40 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 $6,000 of these allocated general overhead costs would be avoided. In addition, the space used to produce part B76 could be used to make more of one of the company's other products, generating an additional segment margin of $29,000 per year for that product.A. Prepare a report that shows the effect on the company's total net operating income of buying part B76 from the supplier rather than continuing to make it inside the company.B. Identify which alternative the company should choose and explain why.C. Determine what errors managers may make when considering make or buy decisions and basing the decision solely on the data?

Answer 1

12,000 units

outside supplier offers at $27.40 each = $328,800

current relevant costs:

• direct materials $7.20 x 12,000 = $86,400
• direct labor $7.10 x 12,000 = $85,200
• variable overhead $3.50 x 12,000 = $42,000
• supervisor's salary $4.70 x 12,000 = $56,400
• total = $270,000

only $6,000 of allocated fixed costs can be avoided

additional revenue from using the freed space $29,000

A. Prepare a report that shows the effect on the company's total net operating income of buying part B76 from the supplier rather than continuing to make it inside the company.

Keep Buy Differential

producing from vendor amount

production cost $270,000 $0 $270,000

purchase cost $0 $328,800 ($328,800)

avoidable costs $0 ($6,000) $6,000

additional revenue $0 ($29,000) $29,000

total $270,000 $293,800 ($23,800)

B. Identify which alternative the company should choose and explain why.

The company should keep producing the part because production costs are lower than buying it from an outside vendor.

C. Determine what errors managers may make when considering make or buy decisions and basing the decision solely on the data?

If we had made this decision based on total production costs, then management would have erroneously chosen to purchase the part from an outside vendor. Total production costs are $28.30 per unit, but almost $5.80 per unit are not avoidable (mostly fixed and general overhead), so the company will incur them no matter what. You have to compare only relevant costs or revenues.