“In my opinion, we ought to stop making our own drums and accept that outside su
ID: 2599338 • Letter: #
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 $19 per drum, we would be paying $5.45 less than it costs us to manufacture the drums in our own plant. Since we use 85,000 drums a year, that would be an annual cost savings of $463,250.” Antilles Refining’s current cost to manufacture one drum is given below (based on 85,000 drums per year): Direct materials $ 10.70 Direct labor 5.50 Variable overhead 1.50 Fixed overhead ($3.70 general company overhead, $2.05 depreciation, and, $1.00 supervision) 6.75 Total cost per drum $ 24.45 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 $255,000 per year. Alternative 2: Purchase the drums from an outside supplier at $19 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 ($85,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 125,000 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 85,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier? 2. Assuming that 100,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier? 3. Assuming that 125,000 drums are needed each year, what is the financial advantage (disadvantage) of buying the drums from an outside supplier? (For all requirements, enter any "disadvantages" as a negative value. Do not round intermediate calculations.)
Explanation / Answer
Cost Per Drum if it is Produced -
Direct materials ( would not be affected by the new equipment.) = $ 10.70
Direct labor (would reduce by 30%.) 5.50 x 70% = $3.85
Variable overhead (would reduce by 30%.) 1.50 x 70% = $1.05
1. Annual Requirement = 85,000 Drums
If The equipment would be rented for $255,000 per year
Equipment Rental Per Unit = $255000 / 85000 = $3
Supervision cost = $85,000 per year
Supervision cost Per Unit = $85000 / 85000 = $1
Statement Showing Defferential Cost Per Unit
Differencial Cost Per Unit = ($19.6 - $19) = $0.60
So there is gain of ( 85000 x $0.60 ) = $51000 in total if drums bought from outside supplier.
2. Annual Requirement = 100,000 Drums
If The equipment would be rented for $255,000 per year
Equipment Rental Per Unit = $255000 / 100000 = $2.55
Supervision cost = $85,000 per year
Supervision cost Per Unit = $85000 / 100000 = $0.85
Statement Showing Defferential Cost Per Unit
Differencial Cost Per Unit = ($19 - $19) = $0
So there is no gain no loss if drums bought from outside supplier.
3. Annual Requirement = 125,000 Drums
If The equipment would be rented for $255,000 per year
Equipment Rental Per Unit = $255000 / 125,000 = $2.04
Supervision cost = $85,000 per year
Supervision cost Per Unit = $85000 / 125,000 = $0.68
Statement Showing Defferential Cost Per Unit
Differencial Cost Per Unit = ($18.32 - $19) = ($0.68)
So there is loss of (125,000 x $0.68 ) = $85000 in total if drums bought from outside supplier.
[Note - Total general company overhead will remain same in both cases (make or buy). Thats why, it is not considered in computing differential cost per unit]
Particulars Make Buy Outside supplier Price $19 Direct material $ 10.70 Direct labor $3.85 Variable overhead $1.05 Total Variable Cost Per Unit $15.60 Supervision cost Per Unit $1 Equipment Rental Per Unit $3 Total Cost Per Unit $19.6 $19Related Questions
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