Item I51 is used in one of Policy Corporation\'s products. The company makes 18,

ID: 2597436 • Letter: I

Question

Item I51 is used in one of Policy Corporation's products. The company makes 18,000 units of this Item each year. The company's Accounting Department reports the following costs of producing the Item at this level of activity:

An outside supplier has offered to produce this Item and sell it to the company for $15.80 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the Item was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company. If the outside supplier's offer were accepted, only $26,000 of these allocated general overhead costs would be avoided.
If management decides to buy Item I51 from the outside supplier rather than to continue making the Item, what would be the annual impact on the company's overall net operating income?

-Net operating income would decline by $81,800 per year.

-Net operating income would decline by $55,800 per year.

-Net operating income would decline by $119,800 per year.

-Net operating income would decline by $29,800 per year.

Per Unit Direct materials $ 1.20 Direct labor $ 2.20 Variable manufacturing overhead $ 3.30 Supervisor’s salary $ 1.00 Depreciation of special equipment $ 2.70 Allocated general overhead $ 8.50

Explanation / Answer

Solution:

Question is related on the decision making based on relevant cost whether to make or buy the product.

Relevant Cost is the cost which will be incurred in future and different under each alternative course of action. The following costs are considered as relevant cost:

- Direct material cost

- Direct labor cost

- Variable manufacturing overhead

- Variable Cost of Goods Sold

- Variable selling and administrative expenses

The above costs are the variable cost which will vary with the production volume. Hence these costs have both the characteristic of relevant cost i.e. it is a future cost and different under each alternative course of action.

Irrelevant cost is the costs which do not play any role in decision making. Irrelevant Cost is the SUNK Cost which has already been incurred and does not change whether company accept or reject the order. Hence it is treated as IRRELEVANT COST.

Relevant Cost for Making of Product and Buying from Outside

Make

Buy

Net Increase or (Decrease) in Operating Income if company buy the product from outside

Direct Material

$21,600

Direct Labor

$39,600

Variable manufacturing overhead

$59,400

Supervisor’s salary

$18,000

Purchase Price offered by the supplier

(18,000 Units x $15.80)

$284,400

-$284,400

Saving in general overhead if purchased from outside

$26,000

Net Increase or (Decrease) in operating income

-$119,800

Hence, the correct option is Net operating income would decline by $119,800 per year