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

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, NV., of Aruba. "At a price of $21 per drum, we would be paying $4.70 less than it costs us to manufacture the drums in our own plant. Since we use 70,000 drums a year, that would be an annual cost savings of $329,000." Antilles Refining's current cost to manufacture one drum is given below (based on 70,000 drums per year) Direct materials Direct labor Variable overhead Fixed overhead ($3.10 general $10.50 7.50 1.50 company overhead, $1.90 depreciation, and, $1.20 supervision) 6.20 Total cost per drum $25.70 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 $252,000 per year. Alternative 2: Purchase the drums from an outside supplier at $21 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 ($84,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment's capacity would be 105,000 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. Assuming that 70,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier? 2. Assuming that 80,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier? 3. Assuming that 105,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier?

Explanation / Answer

Revised variable cost of producing with rented equipment is as follows:

Relavant fixed cost =rent of the equipment per year ie.,$252,000.

=$252,000

So, if 70000 drums are produced with the new machine, it would be contributing towards fixed expenses to the extent of ($21-$16.8)*70000

=$294,000

So, if the drums are produced it is creating a cost savings that would contribute to the allocated overhead costs to the extent of

=$294,000.-$252,000.

=$42,000.

Answer for question no.2:

80,000 drums *$4.2

=$336,000.

Contribution towards fixed expenses=$336,000 -$252,000.

=$84,000.

Answer for question no.3:

105,000 drums *$4.2

=$441,000

Contribution towards fixed expenses=$441,000 -$252,000.

=$189,000

Particulars Existing Revised Direct material 10.5 10.5 Direct labour 7.5 5.25 Variable overhead 1.5 1.05 Total variable cost 19.5 16.8

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