\"In my opinion, we ought to stop making our own drums and accept that outside s

Question

"In my opinion, we ought to stop making our own drums and accept that outside supplier's offer" said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. "At a price of $20 per drum, we would be paying $4.45 less than it costs us to manufacture the drums in our own plant. Since we use 65,000 drums a year, that would be an annual cost savings of $289,250." Antilles Refining's current cost to manufacture one drum is given below (based on 65,000 drums per year): Direct materials Direct labor Variable overhead Fixed overhead ($2.50 general company overhead, $1.60 $ 10.95 7.00 1.60 4.90 $ 24.45 depreciation, and, $0.80 supervision) Total cost per drum A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $156,000 per yean Alternative 2: Purchase the drums from an outside supplier at $20 per drum. The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 25%. The old equipment has no resale value. Supervision cost ($52,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipments capacity would be 100,000 drums per year The company's total general company overhead would be unaffected by this decision. (Round all intermediate calculations to 2 decimal places.) Required 1. To assist the managing director in making a decision, prepare an analysis showing the total cost and the cost per drum for each of the two alternatives given above. Assume that 65,000 drums are needed each year a. What will be the total relevant cost of 65,000 drums if they are manufactured internally as compared to being purchased? Total relevant cost (65,000 drums b. What would be the per unit cost of each drum manufactured internally? (Round your answer to 2 decimal places.)

Explanation / Answer

Solution 1a Total relevant cost: Alternative 1 Particulars Per unit cost no. of units Total Cost Material   10.95 65000 711750 Labour by reducing 25% cost 5.25 65000 341250 Overhead by reducing 25% cost 1.2 65000 78000 General Overhead(Not relevant for decision making as it would be incurred by company as a whole) Nil Nil Nil Depreciation (Not relevant) Nil nil Nil Supervision 0.8 65000 52000 Rent of new Equipment 2.4 65000 156000 Total Cost 1339000 1b Cost per drum = Total Cost/No. of drums                                =1339000/65000                                  =20.6 Total relevant cost: Alternative 2 Particulars Per unit cost no. of units Total Cost Buying Cost 20 65000 1300000 General Overhead(Not relevant for decision making as it would be incurred by company as a whole) Nil Nil Nil Depreciation (Not relevant) Nil nil Nil Supervision (Not incurred as the product is being bought from supplier) Nil nil Nil Total Cost 1300000 1c As we see, the total relevant cost in alternative 2 is less. Hence the option to buy is better. 2a-1 Particulars Per unit cost no. of units Total Cost Material   10.95 80000 876000 Labour by reducing 25% cost 5.25 80000 420000 Overhead by reducing 25% cost 1.2 80000 96000 General Overhead(Not relevant for decision making as it would be incurred by company as a whole) Nil Nil Nil Depreciation (Not relevant) Nil nil Nil Supervision 0.65 80000 52000 Rent of new Equipment 1.95 80000 156000 Total Cost 1600000 2a-2 Cost per drum = Total Cost/No. of drums                                =1600000/80000                                =20 2a-3 indifferent . 2b-1 Particulars Per unit cost no. of units Total Cost Material   10.95 100000 1095000 Labour by reducing 25% cost 5.25 100000 525000 Overhead by reducing 25% cost 1.2 100000 120000 General Overhead(Not relevant for decision making as it would be incurred by company as a whole) Nil Nil Nil Depreciation (Not relevant) Nil nil Nil Supervision 0.52 100000 52000 Rent of new Equipment 1.56 100000 156000 Total Cost 1948000 2b-2 Cost per drum = Total Cost/No. of drums                                =1948000/100000                                =19.48 2b-3 As cost per drum is less in alternative 1 i.e. to manufacture internally.

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