Gerenuk Company currently produces a key part at a total cost of $100,000. Annua

Question

Gerenuk Company currently produces a key part at a total cost of $100,000. Annual variable costs are $30,000. Of the annual fixed costs, $10,000 relate specifically to this part. The remaining fixed costs are unavoidable.

Another manufacturer has offered to supply the part annually for $70,000. The facilities currently used to manufacture the part could be used to manufacture a new product with an expected contribution margin of $40,000 per year. Alternatively, the facilities could be rented out at $35,000 per year. Given all of these alternatives, what is Gerenuk Company's lowest net relevant cost for the parts?

You must show your calculations.

Hint: Your three alternatives are (1) make the part, (2) buy the part and manufacture a new product, (3) buy the part and rent out the facilities.

Explanation / Answer

Alternative 1 . Make the part:

Total relevant cost = Variable costs + Avoidable fixed costs = $ (30,000 + 10,000) = $ 40,000

Alternative 2 . Buy the part and manufacture new product:

Total relevant cost = Purchase cost - Contribution margin from new product = $ (70,000 - 40,000) = $ 30,000

Alternative 3 . Buy the part and rent out the facilities:

Total relevant cost = Purchase cost - Annual rental income = $ (70,000 - 35,000) = $ 35,000

Gerenuk's lowest relevant cost is $ 30,000, i.e alternative 2.

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