Question

 Mills Inc. manufacturers 50,000 components per year. The manufacturing cost per unit of the components is as follows:

Direct materials $ 12
Direct labor 13
Variable overhead 5
Fixed overhead 10
Total unit cost $40

An outside supplier has offered to sell the component to Mills Inc. for $35

Required:
a) What is the effect on income if Mills Inc. purchases the component from the outside supplier?
b) Assume that Mills Inc. can avoid $700,000 of the total fixed overhead costs if it purchases the components. Now what is the effect on income if Mills Inc. purchases the component from the outside supplier?

Answer 1

Answer on Question #64295 - Economics - Accounting

Mills Inc. manufacturers 50,000 components per year. The manufacturing cost per unit of the components is as follows:

Direct materials $ 12

Direct labor 13

Variable overhead 5

Fixed overhead 10

Total unit cost $40

An outside supplier has offered to sell the component to Mills Inc. for $35

Required:

a) What is the effect on income if Mills Inc. purchases the component from the outside supplier?

b) Assume that Mills Inc. can avoid $700,000 of the total fixed overhead costs if it purchases the components. Now what is the effect on income if Mills Inc. purchases the component from the outside supplier?

Answer:

a) To answer this assumption conduct analysis for decision-making "make or buy" 50,000 components.

As you can see, is irrelevant fixed costs which can not be avoided in case of purchase components. Thus, the relevant components manufacturing cost is $30 which is $5 less than the cost of their purchase. We can conclude that the company is more profitable to produce components than buying them from the outside supplier.

b) Consider the situation in the light opportunities to reduce fixed costs by purchasing components, then, considering the alternative to "make or buy", given the benefits that the company will lose by continuing production of components instead of purchasing them.

Thus, the relevant production cost component for decision is:

Valid relevant production costs + Opportunity cost

Opportunity costs to attribute differences in fixed costs in the amount of $200,000 (700000-10 * 50000). Based on initial data obtained results:

Analysis for decision taking into account the lost opportunities, $

In this case also advantageous to produce their own components.

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