Question

Part S00 is used in one of Morsey Corporation's products. The company makes 6,000 units of this part each year. The company's Accounting Department reports the following costs of producing the part at this level of activity: An outside supplier has offered to produce this part and sell it to the company for $16.10 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company. If the outside supplier's offer were accepted, only $6,000 of these allocated general overhead costs would be avoided. If management decides to buy part S00 from the outside supplier rather than to continue making the part, what would be the annual impact on the company's overall net operating income?

Answer 1

Question

Part S00 is used in one of Morsey Corporation's products. The company makes 6,000 units of this part each year. The company's Accounting Department reports the following costs of producing the part at this level of activity:

                                                                           $

Direct material                                                  1.4

Direct labour                                                    2.4

Variable manufacturing overhead                  7.2

Supervisors salary                                           3.6

Depreciation of special equipment               8.9

Allocation of general overhead                     4.5

An outside supplier has offered to produce this part and sell it to the company for $16.10 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company. If the outside supplier's offer were accepted, only $6,000 of these allocated general overhead costs would be avoided. If management decides to buy part S00 from the outside supplier rather than to continue making the part, what would be the annual impact on the company's overall net operating income?

Answer:

Impact on overall profit  = $3,000

Explanation:

Relevant costs for this decision includes

1. Variable cost
2. Attributable portion ( avoidable) of fixed overhead

Unit variable cost = 1.4 + 2.4 +7.2 + 3.6= $14.6

Notes

The depreciation of equipment cost  is not a relevant cost. it is a sunk cost. Also, only the directly attributable overhead of $6000 would be considered, balance represents unavoidable cost that would be incurred either way

                                                                                                           $

Variable cost of making          (14.6 ×6,000)   =                             87,600

Variable cost of external =    (16.10 ×6,000) =                               96,600

Extra variable cost of buying                                                        9,000

Savings in allocated general overhead                                       (6,000)

Net Savings in cost                                                                         3,000

Impact on overall profit  = $3,000