Company makes 30,000 motors to be used in the productions of its power lawn mowe

Question

Company makes 30,000 motors to be used in the productions of its power lawn mowers. The manufacturing cost per motor at this level of activity is as follows:

Direct materials $9.50

Direct labor $8.60

Variable manufacturing overhead $3.75

Fixed manufacturing overhead $4.35

This motor has recently become available from an outside supplier for $25 per motor. If Company decides not to make the motors, none of the fixed manufacturing overhead would be avoidable and there would be no other use for the facilities. If Company decides to continue making the motor, how much higher or lower will the company's net operating income be than if the motors are purchased from the outside supplier?

A. $130,500 higher.

B. $94,500 higher.

C. $207,000 higher.

D. $36,000 lower.

Explanation / Answer

If the company manufactures the motors:

First, take the number of motors we want to make and multiply it by the amount it costs to make each motor.

We want to make 30,000 motors.

To find the cost per motor we need to add the direct cost of materials, the cost of labor, the variable manufacturing overhead, and the fixed manufacturing overhead costs.

$9.50 + $8.60 + $3.75 + $4.35 = $26.20 <--- This is the amount we have to pay to make each motor.
Now that we know how much it costs to make a motor, we need to multiply that cost by the number of motors we plan to make (which in this case is 30,000)

30,000 motors x $26.20 per motor = $786,000 <--- This is total amount we will have to pay to make 30,000 motors


If the motors are purchased from an outside supplier:

We take the number of motors we want to buy, and the multiply it by the cost per motor as such:

30,000 motors x $25 per motor = $750,000 total cost <---This is the total amount we will have to pay to purchase 30,000 motors at $25 a piece.

HOWEVER, we must also include the fixed manufacturing overhead costs because the problem says that we will not be able to avoid these costs even if we purchase the motors. (NOTE: I like to think of fixed manufacturing overhead as the cable bill. Even if you don't watch it, the cable company is going to send you a bill every month). In this case, the fixed manufacturing overhead is the cost of running the facility. Whether the make or buy the motors, they will still all be there doing business.
Therefore, we must take the cost of buying the motors and add it to the cost of running the factory times

30,000 x $4.35 = $130,500 <--- Note: we multiplied $4.35 times the 30,000 because we will incur $4.35 in fixed costs for each motor we purchase.

Now we must add this number to our bill for purchasing the 30,000 motors.

$130,500 + $750,000 = $880,500 <--- This is the total cost we will incur for purchasing the motors and continuing business.


If we make the motors ourselves, it will cost us $786,000, but if we buy them it will cost us $880,500.

$880,500 - $786,000 = $94,500 <--- This means that it will cost us $94,500 less to continue making the motors. Therefore, if Company decides to continue making the motor, the company's net operating income will be $94,500 higher (because you save more). So the answer is actually B (not A). Please remember to rate - thanks!

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