Question

Futura Company purchases the 40,000 starters that it installs in its standard line of farm tractors from a supplier for the price of $8.40 per unit. Due to a reduction in output, the company now has idle capacity that could be used to produce the starters rather than buying them from an outside supplier. However, the company's chief engineer is opposed to making the starters because the production cost per unit is $9.20 as shown below:
Per unit Total
Direct materials ........................................... $3.10
Direct labor.................................................... 2.70
Supervision................................................... 1.50 $60,000
Depreciation................................................. 1.00 $40,000
Variable manufacturing overhead.............. 0.60
Rent.............................................................. 0.30 $12,000
Total production cost.................................. $9.20

If Futura decides to make the starters, a supervisor would have to be hired (at a salary of $60,000) to oversee production. However, the company has sufficient idle tools and machinery such that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The total rent on the plant is $80,000 per period. Depreciation is due to obsolescence rather than wear and tear.

Required:
What is the financial advantage (disadvantage) of making the 40,000 starters instead of buying them from an outside supplier?

Answer 1

Answer:

By producing the starters the company will save $20,000 per year.

Explanation:

                       production costs

direct materials                                      $3.10 per unit

direct labor                                             $2.70 per unit

supervision                                            $60,000

depreciation                                          $40,000

variable manufacturing overhead        $0.60 per unit

rent                                                         $12,000

total production cost                             $9.20 per unit

The engineer is wrong because he is considering fixed costs like depreciation and rent that should not be included because they are independent on whether this project is approved or not. Once you take away depreciation and rent, the cost per unit will fall by $1.30 [= ($40,000 + $12,000) / 40,000 units].

Since the production cost = $9.20 - $1.30 = $7.90, which is lower than $8.40 which is the purchase cost, the company should start producing the starters at least until its sales bonce back.

By producing the starters the company will save ($8.40 - $7.90) x 40,000 units = $20,000 per year