Teich Inc. is considering whether to continue to make a component or to buy it f

Question

Teich Inc. is considering whether to continue to make a component or to buy it from an outside supplier. The company uses 15,000 of the components each year. The unit product cost of the component according to the company's absorption cost accounting system is given as follows:

Assume that direct labor is a variable cost. Of the fixed manufacturing overhead, 10% is avoidable if the component were bought from the outside supplier; the remainder is not avoidable. In addition, making the component uses 3 minutes on the machine that is the company's current constraint. If the component were bought, time would be freed up for use on another product that requires 6 minutes on this machine and that has a contribution margin of $8.10 per unit.
When deciding whether to make or buy the component, what cost of making the component should be compared to the price of buying the component?

$15.55 per unit

$11.50 per unit

$19.15 per unit

$15.10 per unit

Direct materials $7.90 Direct labor      2.10 Variable manufacturing overhead           1.10 Fixed manufacturing overhead         4.00 Unit product cost            $15.10

Explanation / Answer

PART A:

Particulars

Per Unit

Direct materials

7.9

Direct labor   

2.1

Variable manufacturing overhead  

1.1

Unit Variable cost   for Making

11.1

Cost of making the component=$11.1

PART B:

Contribution Earned by making another Component and buying existing Component from outside:

Step 1: time available by buying existing component from outside:

                = No of units buying from outside x time required to make inhouse

                =15,000 X 3 mins =45,000 mins

Step 2: No of new component can be make with 45,000 mins with each component for 6 mins

                =45000/6 =7,500 units

                = Contribution for 7,500 units with a contribution of $8.1 per unit =7,500 x 8.1=$60,750

Step 3 Additional Saving in fixed cost i.e 10 % of $ 4 per unit.

                So by purchasing 15,000 units from outside we can save =15,000 x 4 x 10%=$6,000

Step 4: Total saving is $ 60,750 + $ 6000=$ 66,750 (ie from step 2 and 3)

Step 5: So additionally we still can pay upto $66,750/15,000= $ 4.45

Hence Cost of making the component=$11.1

And Maximum amount we can pay is $11.1 + $4.45=$15.55(i.e variable cost of making + additional benefit)

Unavaoidable Fixed cost is irrevant for decision making.

Particulars

Per Unit

Direct materials

7.9

Direct labor   

2.1

Variable manufacturing overhead  

1.1

Unit Variable cost   for Making

11.1

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