Pure Comfort manufactures and sells mattresses with adjustable air chambers. Pur

ID: 2472027 • Letter: P

Question

Pure Comfort manufactures and sells mattresses with adjustable air chambers. Pure Comfort has been producing and selling approximately 500,000 units per year. Each units sells for $600, and there are no variable selling, general, or administrative costs. The company has been approached by a foreign supplier who wishes to provide the air compressor component for $90 per unit. Total annual manufacturing costs, including air compressors, is as follows: Direct materials $50,000,000 Direct labor 80,000,000 Variable factory overhead 16,000,000 Fixed factory overhead 35,000,000 If Pure Comfort outsources the air compressor, it is expected that direct materials will be reduced by 20%, direct labor by 30%, and variable factory overhead by 25%. There will be no reduction in fixed factory overhead. (a) Should Pure Comfort outsource the air compressor? (b) If outsourcing the air compressor will free up capacity, and enable Pure Comfort to increase production and sales to 600,000 units per year, would it make sense to outsource?

Explanation / Answer

Solution:

Part (a)

This part is related to the concept of whether firm manufacture (make) the product in house or they buy product from outside market instead of making in house.

Points to be considered while evaluation the in house manufacturing of product or buy from outside

-- In make or buy decision, the price asked by the outside suppliers should be compared with the variable cost of producing the component parts.

-- If the variable/marginal cost is lower than the price demanded by the outside suppliers, the component parts should be manufactured in the factory itself to utilize its capacity.

-- Fixed expenses are not considered in the cost of manufacturing component parts (Assumption – Fixed Costs have been already incurred and treated as Sunk Cost & the additional cost involved is only variable cost which is relevant cost for decision making)

Hence, we need to find out first the total variable cost per unit of making product in house

Total Variable Cost of Manufacturing Product

Direct materials

$50,000,000

Direct labor

$80,000,000

Variable factory overhead

$16,000,000

Total Variable Cost

$146,000,000

Per Unit Cost ($146,000,000 / 500,000)

$292

Total Cost If company buy component from Outside Supplier

Component Cost Demanded by Supplier ($90 x 500,000)

$45,000,000

Direct Materials ($50,000,000 x 80%)

$40,000,000

Direct labor ($80,000,000 x 70%)

$56,000,000

Variable factory overhead ($16,000,000 x 75%)

$12,000,000

Total Cost if company buy component from outside

$153,000,000

Per Unit Cost ($153,000,000 / 500,000)

$306

From the above statements of cost, it is clear that Total Variable Cost of Manufacturing product in house is lower than the cost of buying component from outside. Hence Pure Comfort should not outsource the air compressor.

Note -- Fixed factory overhead is treated as SUNK COST. Hence this cost play no role in decision making because if company accept the offer or not, this cost will be incurred.

Part (b) If outsourcing the air compressor will free up capacity, and enable Pure Comfort to increase production and sales to 600,000 units per year, would it make sense to outsource?

In this case the idle capacity of the company will be utilized.

Hence, we need to calculate the additional contribution margin that will company earn due to free up or utilizing the idle capacity.

Cost Loss Due to outsource the component

(306 - $292) x 500,000

($7,000,000)

Increase in Contribution Due to free up the capacity

($600 - $306) x 100,000

$29,400,000

Increase in Profit due to free up the capacity

$22,400,000

If outsourcing the air compressor will free up capacity, and enable Pure Comfort to increase production and sales to 600,000 units per year, It will increase the profit of the company by $22,400,000.

Hence , the offer for outsourcing the component should be accepted.

Company will outsource the component 500,000 Units from outside supplier at total cost as calculated above from outsourcing the component and 100,000 units produced in house due to free up the capacity at manufacturing variable cost.

Please feel free for any clarification...