a. Make or Buy Terry Inc. manufactures machine parts for aircraft engines. CEO B

Question

a. Make or Buy Terry Inc. manufactures machine parts for aircraft engines. CEO Bucky Walters is considering an offer from a subcontractor to provide 2,300 units of product OP89 for $110,400. If Terry does not purchase these parts from the subcontractor, it must continue to produce them in-house with these costs:

Costs per Unit

Direct materials $25

Direct labor 14

Variable overhead 12

Allocated fixed overhead 5

Required: Calculate the relevant cost for producing the product.

Calculate the relevant cost for producing the product.

Calculate the additional cost or savings of producing the product internally versus purchasing the product externally, from a supplier..

Calculate the additional cost or savings of producing the product internally versus purchasing the product externally, from a supplier..

Additonal cost of producing internally

Explanation / Answer

Fixed overhead are sunk costs and have to be incurred even if production is not done (except avoidable fixed costs). Assuming that the above fixed costs are un avoidable, the organization has to incur these costs even if production is not done. So, these costs are not relevant in determining whether to manufacture internally or not.

The relevant costs are the variable costs consisting of material, labor and variable overhead.

So, Relevant costs of producing internally = $25 + $14 + $12 = $51

Cost of outsouring per unit = Total outsourcing cost / Number of units = $110,400 / 2,300 units = $48 per unit.

So, Savings per unit due to outsouring = $51 - $48 = $3 per unit.

Total savings for 2,300 units = 2,300 x $3 = $6,900

So, the offer will result in savings of $6,900 and should be accepted.

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