Outsourcing Decision 3. The Coil Company manufactures 10,000 rolls of cable each
ID: 2472066 • Letter: O
Question
Outsourcing Decision
3. The Coil Company manufactures 10,000 rolls of cable each period. The cable is used as an input for producing several other products that Coil manufactures. The full manufacturing costs for a batch of 100 rolls of cable are:
Direct materials
$170
Direct labor
100
Variable manufacturing overhead
100
Average fixed manufacturing overhead
175
Total
$545
The fixed manufacturing overhead is comprised of depreciation expenses related to prior investments in facilities and equipment that are used in the manufacturing of the cable. These assets have no other use than for the manufacturing of the cable. An outside supplier has offered to sell Coil the 10,000 rolls of cable necessary to meet production needs this period for a lump-sum of $45,000.
If Coil accepts this outside supplier’s offer, how much better or worse off will the company be?
Direct materials
$170
Direct labor
100
Variable manufacturing overhead
100
Average fixed manufacturing overhead
175
Total
$545
Explanation / Answer
Solution:
This question is related to the concept of whether firm manufacture (make) the product in house or they buy product from outside market instead of making in house.
Points to be considered while evaluation the in house manufacturing of product or buy from outside
-- In make or buy decision, the price asked by the outside suppliers should be compared with the variable cost of producing the component parts.
-- If the variable/marginal cost is lower than the price demanded by the outside suppliers, the component parts should be manufactured in the factory itself to utilize its capacity.
-- Fixed expenses are not considered in the cost of manufacturing component parts (Assumption – Fixed Costs have been already incurred and treated as Sunk Cost & the additional cost involved is only variable cost which is relevant cost for decision making)
Hence, we need to find out first the total variable cost of making 10,000 rolls in house
Variable Cost
100 Rolls
10,000 Rolls
Direct materials
$170
$17,000
Direct labor
$100
$10,000
Variable manufacturing overhead
$100
$10,000
Total Variable Cost
$370
$37,000
The price offered / demanded by the outside supplier for rolls = $45,000
Hence, the price demanded by the outside supplier for 10,000 Rolls is higher than Variable Cost of Manufacturing 10,000 rolls in house, the rolls should be manufactured in the factory itself.
If Coil accepts this outside supplier’s offer, the company will incur a loss of $8,000 ($45,000 - $37,000).
Note --- Average fixed manufacturing overhead is treated as SUNK COST. Hence this cost play no role in decision making because if company accept the offer or not, this cost will be incurred.
Variable Cost
100 Rolls
10,000 Rolls
Direct materials
$170
$17,000
Direct labor
$100
$10,000
Variable manufacturing overhead
$100
$10,000
Total Variable Cost
$370
$37,000
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