Question

A company currently makes a component used in production. The per unit costs incurred to make the component include: Direct materials: $5; Direct labor: $2; Overhead: $4; Total cost: $11. Twenty-five percent of the overhead costs are considered incremental. The company can purchase the component from another source for $10. The company should do which of the following?
The company should not make the components because incremental costs are $2 less than the purchase price
The company should make the components because incremental costs are $2 less than the purchase price
None of above

Answer 1

Answer:

The company should make the components because incremental costs are $2 less than the purchase price

Explanation:

The cost of making each unit of component = Direct Labour + Direct Material + Variable Overhead*

*The overhead cost of $4 contains both a fixed and variable element. It has been mentioned that 25% of overhead cost is incremental i.e. it increases with each additional unit produced (marginal cost). The incremental cost is the variable element.

Variable element = $4 x 25% = $1

Fixed element = $4 x 75% = $3

Thus, the cost of making each unit of component = $5 + $2 + $1 = $8,

whereas the cost of purchasing each unit of complement is $10. Hence, the company should produce the component as it is less by $2 ($10 - $8) to produce than it is to purchase.