2. There are three alternatives available to meet the demand of a particular pro

Question

2. There are three alternatives available to meet the demand of a particular product. They are as follows: (a) Manufacturing the product by using process A (b) Manufacturing the product by using process B (c) Buying the product. The details are as given in the following table: Cost Elements Buy Manufacturing the product by using process A 400,000 35 Manufacturing the product by using process B 200,000 50 Fixed cost/year Variable cost/unit Purchase cost/ unit 110 a- Determine the breakeven points for each pair of the options. b- Specify the range at which each option should be selected c- If the annual demand of the product is 8,000 units. Should the company make the product using process A or process B or buy it?

Explanation / Answer

Indifference level of output =   Difference in fixed cost

Difference in variable cost per unit

= 400,000 - 200,000

50 - 35

= 200,000

15

= 13,333.33 units

Hence, when 13,333 units are produced in a year, cost of production will be same from process A and process B.

Hence, when output is less than 13,333 units, cost per unit will be lowest in process B. When output is more than 13,333 units, it will be economical to use process A since per unit cost will go on reducing beyond 13,333 units. When the output is less than 3,333 units, it will be economical to buy the product from outside since cost per unit will be lowest in this case. This output range has been calculated as under:

Let the output be Y units when total cost is same in process B and cost of buying from outside

Y x 110 = Y x 50 + 200,000

60Y = 200,000

Y = 200,000/60

= 3,333.33

Hence, when output is 3,333 units, total cost will be same in process B and cost of buying from outside.

Hence, when demand is less than 3,333 units, product should be bought from outside.

When demand is more than 3,333 units but less than 13,333 units, process B should be used.

When demand is more than 13,333 units, process A should be used.

(c)

When annual demand is 8,000 units, process B should be used since total cost will be lowest which can be proved as under:

Total cost using process A = 400,000 + 8,000 x 35

= $680,000

  

Total cost using process B = 200,000 + 8,000 x 50

= $600,000

Cost of buying 8,000 units = 8,000 x 110

= $880,000

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