Han Products manufactures 30,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is:
Direct materials: $3.60
Direct labor: 10.00
Variable manufacturing overhead: 2.40
Fixed manufacturing overhead: 9.00
Total cost per part: $25.00
An outside supplier has offered to sell 30,000 units of part S-6 each year to Han Products for $21 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $80,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier.
Calculate the per unit and total relevant cost for buying and making the product?
How much will profits increase or decrease if the outside supplier's offer is accepted?
Costs which are relevant for the purpose of decision making are called relevant costs. Relevant costs are decided on the basis of whether the cost item is necessary for taking the required make or buy decision.
Answer and Explanation:
a. Total savings if Han products decide to buy the product from outside supplier:
Price charged by outside supplier = 30,000 x $21 p.u. = $630,000
Rental income from manufacturing facilities = ($80,000)
Relevant Fixed overhead that will still continue ($9 x 30,000 x 2/3) = $180,000
Net cost of buying the parts = $730,000
b. Total cost of making the product:
DM = $3.60
DL = $10
VOH = $2.40
FMOH = $3($9 - $9 x 2/3)
Total cost p.u. = $19 p.u.
Total cost = $19 x 30,000 = $570,000
If supplier's offer is accepted then profits will decrease by ($730,000 - $570,000) = $160,000
Remark: Since two-third of fixed overheads will continue even if production for S6 parts is discontinued, the cost of making the product is a better option for Han Products.
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from Accounting 301: Applied Managerial AccountingChapter 9 / Lesson 12