Question

Mcfarlain Corporation is presently making part U98 that is used in one of its products. A total of 7,000 units of this part are produced and used every year. The company's Accounting Department reports the following costs of producing the part at this level of activity: Per Unit Direct materials $ 3.70 Direct labor $ 3.60 Variable overhead $ 1.40 Supervisor's salary $ 4.00 Depreciation of special equipment $ 3.90 Allocated general overhead $ 4.10 An outside supplier has offered to produce and sell the part to the company for $17.10 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 part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company, none of which would be avoided if the part were purchased instead of produced internally. If management decides to buy part U98 from the outside supplier rather than to continue making the part, what would be the annual financial advantage (disadvantage)?

Answer 1

Answer: Financial disadvantage of -$30,800

Explanation:

If purchased externally then the equipment used in production will no longer be used therefore its depreciation would be irrelevant to the unit.

The fixed costs would be incurred regardless so will not factor in the decision either.

Therefore the total relevant cost of producing internally is;

= (Direct materials + Direct labor + Variable overhead + Supervisor's salary) * Units produced

= (3.7 + 3.6 + 1.4 + 4) * 7,000

= 12.7 * 7,000

= $88,900

If Part U98 is purchased from outside at $17.10 a unit;

= 7,000 * 17.10

= $119,700

Total Financial advantage (disadvantage)

= Variable cost and supervisor salary - Cost of purchasing outside

= 88,900 - 119,700

= -$30,800

= (30,800)