Problem 4 Gibson, Inc. manufactures a subcomponent that it needs for the product

Question

Problem 4

Gibson, Inc. manufactures a subcomponent that it needs for the production of its main product. Gibson currently makes, and uses, 100,000 of these subcomponents per year. The per-unit production costs of the subcomponent follow:

Direct materials $2.60 Direct labor 1.00 Manufacturing overhead: Variable 1.20

Fixed 1.60 Total cost per unit $6.40

Quaid, Inc. has offered to sell Gibson all 100,000 units it will need during the coming year for $6.00 per unit. If Gibson accepts the offer from Quaid, the facilities used to manufacture the subcomponent could be used elsewhere in production. This change would save Gibson $90,000 in the fixed costs of producing its main product. In addition, a $50,000 cost item included in fixed factory overhead which is specifically related to producing this subcomponent (rental of special equipment not usable in the manufacture of other products) would be eliminated.

Required: Determine whether Gibson should make the component or buy it from Quaid. What is the effect on operating income if your advice is followed?

Explanation / Answer

If Gibson desires to make subcomponents on their own, cost to incurred for manufacturing product =$640,000(6.4*100000)

If Gibson go for buying subcomponents from Quaid, amount to be paid

Costof material =$600,000 (6*100000)

Less :Savings in fixed costs =$ 140000

Total to be paid= $ 460000

Decision

Gibson should buy subcomponents from Quaid as buying cost is less than the manufacturing cost

Effect On operating income (positively) is $ 180,000

(640,000-460000)

Note:decision can be done alternatively on the basis of incremental cost approch

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