\"In my opinion, we ought to stop making our own drums and accept that outside s
ID: 2444147 • Letter: #
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 18 florins per drum, we would be paying 5 florins less than it costs us to manufacture the drums in our own plant. (The currency in Aruba is the florin, denoted below by fl.) Since we use 60,000 drums a year, that would be an annual cost savings of 300,000 florins." Antilles Refining's present cost to manufacture one drum is given below (based on 60,000 drums per year):
Direct materials fl 10.35
Direct labor 6.00
Variable overhead 1.50
Fixed overhead (fl2.80 general company overhead,
fl1.60 depreciation and, fl0.75 supervision) 5.15
Total cost per drum
fl 23.00
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 fl135,000 per year.
Alternative 2: Purchase the drums from an outside supplier at fl18 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 30%. The old equipment has no resale value. Supervision cost (fl45,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment's capacity would be 90,000 drums per year.
The company's total general company overhead would be unaffected by this decision.
Requirement 1:
The president is unsure what the company should do and would like an analysis showing the drum costs and total costs for each of the two alternatives given above. Assume that 60,000 subassemblies are needed each year.
(a)
What will be the total relevant cost of 60,000 subassemblies if they are manufactured internally as compared to being purchased? (Omit the "fl" sign in your response.)
Total relevant cost fl
(b) What would be the per drum cost of the each subassembly manufactured internally? (Round your answer to 1 decimal place. Omit the "fl" sign in your response.)
Cost of subassembly fl
Explanation / Answer
1. The cost of supervision is relevant to the decision because this cost can be avoided by buying the drums. 2. A. The company would be indifferent between the two alternatives if 75,000 drums were needed each year. Differential Cost Per Drum Total Differential Cost-75,000 Drums Make Buy Make Buy Outside supplier’s price fl18.00 fl1,350,000 Direct materials fl10.35 fl776,250 Direct labor 4.2 315,000 Variable overhead 1.05 78,750 Supervision 0.6 45,000 Equipment rental 1.80 135,000 Total cost fl18.00 fl18.00 fl1,350,000 fl1,350,000 b. The company should rent the new equipment and make the drums if 90,000 units per year are needed. Differential Costs Per Drum Total Differential Cost-90,000 Drums Make Buy Make Buy Outside supplier’s price fl18.00 fl1,620,000 Direct materials fl10.35 fl931,500 Direct labor 4.2 378,000 Variable overhead 1.05 94,500 Supervision 0.5 45,000 Equipment rental 1.50 135,000 Total cost fl17.60 fl18.00 fl1,584,000 fl1,620,000 3. Other factors that the company should consider include: a. Will volume in future years increase, or will it remain constant at 60,000 units per year? b. Can quality control be maintained if the drums are purchased from the outside supplier? c. Will costs for materials and labor increase in future years? d. Will the outside supplier dependably meet shipping schedules? e. Can the company begin making the drums again if the supplier proves to be undependable? Are there alternative suppliers? f. What is the labor outlook in the supplier’s industry g. If the outside supplier’s offer is accepted and the need for drums increases in future years, will the supplier have the added capacity to provide more than 60,000 drums per year? h. Will the rental cost of the equipment change in the future?
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