X Company currently makes a part and is considering buying it next year from a c

Question

X Company currently makes a part and is considering buying it next year from a company that has offered to supply it for $17.36 per unit. This year, total costs to produce 56,000 units were:

Of the overhead costs, $89,600 were fixed, and $68,992 of these fixed overhead costs are unavoidable even if X Company buys the part. Production next year is not expected to change. If X Company continues to make the part instead of buying it, it will save

Explanation / Answer

Relevant cost of production will be variable costs + Relevant fixed costs

Relevant fixed costs are costs which can be avoided. Sunk costs or unavoidable fixed costs are not considered in decision making as they have to be incurred even if production is not done

So, Variable costs

= Direct materials + Direct labor + (overhead – Fixed overhead)

= $352,800 + $291,200 + ($330,400 - $89,600)

= $884,800

Relevant fixed costs

= Total fixed costs - unavoidable fixed costs

= $89,600 - $68,992

= $20,608

So, Total relevant costs per unit

= Variable + Fixed

= $884,800 + $20,608

= $905,408

Relevant cost per unit

= Total costs / Number of units

= $905,408 / 56,000

= $16.168 per unit

So, Total savings due to production

= (Purchase price – Relevant cost per unit) x Number of units

= ($17.36 - $16.168) x 56,000

= $66,752

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