Question

Innova uses 1,000 units of the component IMC2 every month to manufacture one of its products. The unit costs incurred to manufacture the component are as follows. Direct materials $61.48 Direct labor 37.19 Overhead 126.50 Total $225.17 Overhead costs include variable material handling costs of $7.16, which are applied to products on the basis of direct material costs. The remainder of the overhead costs are applied on the basis of direct labor dollars and consist of 60% variable costs and 40% fixed costs. A vendor has offered to supply the IMC2 component at a price of $230 per unit. (a) Prepare the incremental analysis for the decision to make or buy IMC2. Make IMC2 (per unit) Buy IMC2 (per unit) Net Income Increase (Decrease) Direct material $ $ $ Direct labor Material handling Variable overhead Purchase price Total unit cost $ $ $ Should Innova purchase the component from the outside vendor if Innova’s capacity remains idle?

Answer 1

Answer:

Innova

a) Make or Buy IMC2 Incremental Analysis:

Make IMCs (per unit)

Direct material         $61.48

Direct labor                37.19

Material handling        7.16

Variable overhead    71.60

Total unit cost          177.43

Buy IMC2 (per unit)

Purchase price          $230

Net Income will decrease by ($52.57) if IMC2 is bought.

b) Innova should not purchase the component.  It costs more to buy IMC2 than to make it based on incremental analysis.

Explanation:

a) Incremental Analysis is a decision-making technique used in business to determine the true cost difference between alternatives.  It is also called the relevant cost approach, marginal analysis, or differential analysis.  Using incremental analysis, sunk cost or past cost is disregarded as irrelevant.  The fixed cost element equalling $47.74 per unit is a sunk cost that is not relevant for incremental analysis.

b) In a make or buy decision, the company considers if internalization of production will be of greater economic benefits than outsourcing.

c) Variable overhead is calculated as ($126.50 - $7.16) x 60% = $71.60