Question

Snipe Company has been purchasing a component, Part Q, for $19.20 a unit. Snipe is currently operating at 70% of capacity and no significant increase in production is anticipated in the near future. The cost of manufacturing a unit of Part Q, determined by absorption costing methods, is estimated as follows:
Direct materials $11.50

Direct labor 4.50

Variable factory overhead 1.12

Fixed factory overhead 3.15

Total $20.27

Calculate the income (loss) per unit for the company to (1) buy the product and the (2) differential effect on income, and (3) determine the decision the company should make.

Answer 1

Answer:

See Explanation.

Explanation:

The company is incurring a relevant loss on purchase of Q rather than manufacturing it as,

When there is spare capacity only the relevant costs are identified to see if the decision to buy or make is worth it.

Since the factory fixed overhead is to be paid regardless of manufacturing Q, it should not be included in the estimations and the total cost of manufacturing Q should be

Direct Material + Direct Labor + Variable overheads

So Direct costs = 11.5 + 4.5 + 1.12 = $17.12

So the loss the company is incurring by purchasing Q = $19.20 - 17.12

Loss = $2.08/Q

Differential effect on the income is $2.08/ purchase of Q.

This can be avoided and thus Snipe should consider manufacturing Q rather than purchasing it as relevant direct costs give it an opportunity to make savings as there are no planned increases in production anyway.

Hope that helps.