Question

Scott Corporation produces a part for use in the production of one of its products. The per-unit costs associated with the annual production of 1,000 units of this part are as follows: Direct Materials $10.50 Direct labor $24.00 Variable factory overhead $ 5.50 Fixed factory overhead $12.00 Total Costs $52.00 $5,000 of the fixed factory overhead costs associated with the production of this product are common fixed costs. Larson Company has offered to sell 1,000 units of the same part to Scott Corporation for $42 per unit. Scott should:

Answer 1

Considering only the relevant costs, it is more cost-effective for the Scott Corporation to continue producing the part internally since it costs $40 per unit to make, which is less than Larson Company's offer of $42 per unit. Fixed costs do not change with the decision and should be regarded as sunk costs if not avoidable.

Step-by-step explanation:

The Scott Corporation is faced with a decision related to make-or-buy, which concerns whether it should continue to manufacture a part internally or purchase it from an external supplier, in this case, the Larson Company. To make an informed decision, the company needs to consider only the relevant costs associated with each option. The relevant costs are the costs that will change depending on the decision taken. For Scott Corporation, these include direct materials, direct labor, variable factory overhead, and any avoidable fixed costs. The common fixed cost of $5,000 is not avoidable and thus is irrelevant to the decision.

When Scott produces the part, the total relevant cost per unit is calculated by adding direct materials ($10.50), direct labor ($24.00), and variable factory overhead ($5.50), resulting in a total of $40.00. Fixed factory overhead costs allocated to this part are $7,000 ($12,000 minus the $5,000 common fixed overhead), but these are sunk costs if they cannot be avoided or repurposed for other products. Since the offer from Larson Company is $42 per unit, it would cost Scott $2 more per unit to buy the part than to make it, assuming the fixed costs remain unchanged. Therefore, it would be more cost-effective for Scott to continue producing the part internally, as long as the fixed costs are indeed fixed and unavoidable.

It is important to highlight the principle of spreading the overhead, which means that as the quantity of output increases, the average fixed cost per unit decreases. This is because the total fixed costs are spread over a larger number of units. As a result, producing at higher volumes can reduce the average cost per unit and should be considered in the make-or-buy decision.

Answer 2

It is cheaper to buy the part. The company will save $5,000.

Step-by-step explanation:

Giving the following information:

UNitary production cost:

Direct Materials $10.50

Direct labor $24.00

Variable factory overhead $ 5.50

Total avoidable Fixed factory overhead= (12*1,000) - 5,000= 7,000

Larson Company has offered to sell 1,000 units of the same part to Scott Corporation for $42 per unit.

First, we need to calculate the total cost of making the units:

Total cost= (10.5 + 24 + 5.5)*1,000 + 7,000= $47,000

Now, the total cost of buying them:

Buy= 1,000*42= $42,000

It is cheaper to buy the part. The company will save $5,000.