Answer to Question #277765 in Financial Math for Apple

Question

Currently, Teddy Inc. manufactures part CD7 used in the production of its product, producing 8,000 units annually. An outside supplier is offering to sell the part to Teddy for RM16. The cost of manufacturing CD7 is as follows:

Direct materials RM9.00 , Direct labour = 3.00, Variable overhead=2.50, Fixed overhead=4.00 and the TOTAL=RM18.50

Of the total overhead assigned to CD7, RM28,000 is direct fixed overhead (i.e. the amount is not needed if the product line is dropped). The remaining fixed overhead is common fixed overhead. There is no alternative use for facilities currently used to produce the part.

a.     Should Teddy accept the offer from the outside supplier? What is the most that Teddy is willing to pay?

b.     Can direct material ever be irrelevant in a make-or-buy decision?

Answer 1

a. In order to make a decision about production or purchase, it is necessary to compare the relevant costs with the supplier's offer. Relevant costs are those costs that will go away if production is abandoned:

$Relevant costs=(9+3+2,5)\times8000+28000=144000$

That is, we add up the direct costs per unit of production and multiply by the volume of production, and add those invoices that will go away if production is abandoned. And at the supplier's suggestion, we multiply the unit costs by the volume of production and get the amount that we have to give to the supplier when buying:

$purchase price=8000\times16=128000$

the purchase price is less than the relevant costs, so you can buy.

b. Generally speaking, any cost affects the management decision, but in this example the direct costs did not, it is more profitable to buy than to produce. And so, in addition, if there is no alternative use for the materials, then the cost of materials is a sunk cost and is irrelevant in the 'make or buy' decision.