\"In my opinion, we ought to stop making our own drums and accept that outside s
ID: 2577543 • Letter: #
Question
"In my opinion, we ought to stop making our own drums and accept that outside supplier's offer," said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. "At a price of $19 per drum, we would be paying $4.80 less than it costs us to manufacture the drums in our own plant. Since we use 70,000 drums a year, that would be an annual cost savings of $336,000." Antilles Refining's current cost to manufacture one drum is given below (based on 70,000 drums per year) Direct materials Direct labor Variable overhead Fixed overhead ($3.60 general $1060 5. 1.50 company overhead, $2.00 depreciation, and, $1.10 supervision) 6.7 $23. 8 Total cost per drum A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are Alternative 1: Rent new equipment and continue to make the drums. The equipment would be rented for $231,000 per year. Alternative 2: Purchase the drums from an outside supplier at $19 per drum The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 20%. The old equipment has no resale value. Supervision cost ($77,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment's capacity would be 110,000 drums per year. The company's total general company overhead would be unaffected by this decision. (Round all intermediate calculations to 2 decimal places.)Explanation / Answer
1. 70,000 drums
Calculation of Cost for renting equipment and manufacturing
Particulars
Amount
Cost to manufacture of drums:
Materials
10.60
Labor ($5 x 80%)
4.00
Variable Overheads (($1.50 x 80%)
1.20
Total Relevant cost of manufacturing per drum
15.8
Manufacturing cost of 70,000 drums
1,106,000
Rent of Equipment
231,000
Total Cost
1,337,000
NOTE: Fixed Costs are required to be incurred and is therefore, irrelevant for decision making
Total Purchase cost of Drum = $19 x 70,000 = $1,330,000
Financial Advantage in Purchasing Drums = $1,337,000 - $1,330,000 = $7,000
2. Purchasing 96,250 drums
Calculation of Cost for renting equipment and manufacturing
Particulars
Amount
Cost to manufacture of drums:
Materials
10.60
Labor ($5 x 80)
4.00
Variable Overheads (($1.50 x 80)
1.20
Total Relevant cost of manufacturing per drum
15.8
Manufacturing cost of 96,250 drums
1,520,750
Rent of Equipment
231,000
Total Cost
1,751,750
NOTE: Fixed Costs are required to be incurred and is therefore, irrelevant for decision making
Total Purchase cost of Drum = $19 x 96,250 = $1,828,750
Financial disadvantage in Purchasing Drums = $1,751,750 - $1,828,750 = $(77,000)
Particulars
Amount
Cost to manufacture of drums:
Materials
10.60
Labor ($5 x 80%)
4.00
Variable Overheads (($1.50 x 80%)
1.20
Total Relevant cost of manufacturing per drum
15.8
Manufacturing cost of 70,000 drums
1,106,000
Rent of Equipment
231,000
Total Cost
1,337,000
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