“In my opinion, we ought to stop making our own drums and accept that outside su

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 per drum, we would be paying $6.65 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 $432,250.” Antilles Refining’s current cost to manufacture one drum is given below (based on 65,000 drums per year): Direct materials $ 10.50 Direct labor 7.50 Variable overhead 1.50 Fixed overhead ($2.60 general company overhead, $1.65 depreciation, and, $0.90 supervision) 5.15 Total cost per drum $ 24.65 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 $175,500 per year. Alternative 2: Purchase the drums from an outside supplier at $18 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 ($58,500 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 225,000 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(65000 drums): (b.) What would be the per unit cost of each drum manufactured internally? (Round your answer to 2 decimal places.) Per unit cost of drum: (c) Which course of action would you recommend to the managing director? a. Purchase from the outside supplier b. Manufacture internally OR c. Indifferent between the two alternatives 2a- What will be the total relevant cost of 195,000 drums if they are manufactured internally? Total relevant cost (195000 drums): 2b- What would be the per unit cost of drums? Per unit cost of drum: 2c- What course of action would you recommend if 195,000 drums are needed each year? a. Indifferent between the two alternatives b. Manufacture Internally c. Purchase from outside supplier 2d- What will be the total relevant cost of 225,000 drums if they are manufactured internally? Total Relevant cost (225000 drums): 2e. What would be the per unit cost of drums? (Round your answer to 2 decimal places.) Per unit cost of drum: 2f. What course of action would you recommend if 225,000 drums are needed each year? a. manufacture internally b. purchase from outside supplier c. indifferent between the two alternatives

Explanation / Answer

Working note based on production of 65000 units:

Note: it is assumed that Depreciation and general company fixed overhead will remain unchanged and there will not be any saving.

a. The total relevant cost of 65,000 drums if they are manufactured internally = $1,267,500

b. The per unit relevant cost of each drum manufactured internally = $19.50

c. The course of action would you recommend to the managing director = Purchase from outside

Working notes based on production of 195000 units:

2a. The total relevant cost of 195,000 drums if they are manufactured internally = $3,451,500

2b. The per unit relevant cost of each drum manufactured internally = $17.70

2c. The course of action would you recommend if 195,000 drums are needed each year = Receomended to manufacture internally

Working Note based on production of 225000 units:

2d. The total relevant cost of 225,000 drums if they are manufactured internally =$3,955,500

2e. The per unit relevant cost of each drum manufactured internally = $17.58

2f. The course of action would you recommend if 225,000 drums are needed each year = Receomended to manufacture internally

Alternative 1 Alternative 2 Particulars Rent New Equipment & Manufacture Purchase from outside Direct material 10.5 Direct Labor 7.5*.7 5.25 Variable Overhead 1.5*.7 1.05 Total Variable cost per unit 16.8 Total Variable cost =16.8*65000 1092000 Equipment hiring cost 175500 Total relevant Cost 1267500 Total relevant Cost per unit =1267500/65000 19.5 18 Course of action suggested - Recommended to buy from outside

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