Question

A company currently makes a component used in production. The per unit costs incurred to make the component include: Direct materials: $5; Direct labor: $2; Overhead: $4; Total cost: $11. Twenty-five percent of the overhead costs are considered incremental. The company can purchase the component from another source for $10. The company should do which of the following?

A. The company should not make the components because incremental costs are $2 less than the purchase price.
B. The company should make the components because incremental costs are $2 less than the purchase price.
C. None of above

Answer 1

The company should make the components because incremental costs are $2 less than the purchase price.

Step-by-step explanation:

To solve this we would have to calculate the cost of making each unit of the component.

= Direct Labour + Direct Material + Overhead*

25% of Overhead is said to be Incremental. Overhead is 4. This means that 25% of 4 is the Marginal Cost of production. i.e, the cost per unit.

= 25% * 4

= (25/100) x 4

= 1

We would charge $1 per unit to overhead costs.

Therefore, the cost of making each unit of component

= $5 + $2 + $1 = $8

Since the cost of purchasing each unit of component is $10. Then the company has to produce the component because it is less with a difference of $2.

$10 - $8 = $2