Spahr Company produces a part that is used in the manufacture of one of its prod

Question

Spahr Company produces a part that is used in the manufacture of one of its products. The unit manufacturing costs of this part, assuming a production level of 5,000 units, are as follows:

Direct material $2

Direct Labor 4

Variable manufacturing overhead 3

Fixed manufacturing overhead 1

Total cost $10

The fixed overhead costs are unavoidable

Assume spahr company can purchase 5000 units of the part from allgood company for $13.50 each and the facilities currently used to make the part could be used to manufacture 5000 units of another product that would have a $6 per unit contribution margin. If no additional fixed costs would be incurred, what should spahr company do? Support your answer with the calculation and the change in operating income (profit).

Explanation / Answer

Solution:

Question is related on the decision making based on relevant cost.

Relevant Cost is the cost which will be incurred in future and different under each alternative course of action. The following costs are considered as relevant cost:

- Direct material cost

- Direct labor cost

- Variable manufacturing overhead

- Variable selling and administrative expenses

The above costs are the variable cost which will vary with the production volume. Hence these costs have both the characteristic of relevant cost i.e. it is a future cost and different under each alternative course of action.

Irrelevant cost is the costs which do not play any role in decision making. Irrelevant Cost is the SUNK Cost which has already been incurred and does not change whether company make or buy the product.

Since the question says fixed overhead costs are unavoidable, it means whether company make part or purchase from outside the fixed overhead cost will remain same. Hence it is treated as IRRELEVANT COST.

Relevant Cost per unit for making part

Relevant Cost per unit

Direct materials

$2

Direct labor

$4

Variable Manufacturing Overhead

$3

Total Relevant Cost per unit

$9

Here Relevant Cost per unit for making part is $9 per unit and the price offered by the outside supplier (Allgood Company) is $13.50

If company purchase from outside, the company will have a loss of $4.50 per unit for purchasing parts from outside instead of making in house.

Total Loss if purchase PARTS from outside = 5,000 Units x $4.50 = $22,500

Now, the facilities currently used to make the part could be used to manufacture 5000 units of another product that would have a $6 per unit contribution margin. It is a profit or opportunity to the company. We need to find out total contribution margin from making another product and analysis the same.

Statement of Profitability if company purchase parts from outside and use its facility in making another product having contribution margin per unit $6

$$

Total Contribution Margin from another product

(5,000 Units x $6)

$30,000

Less: Total Loss if purchase PARTS from outside

($22,500)

Increase in Profit

$7,500

The profit of company will increase by $7,500 if the Parts are purchased from outside and the company use its facility in making another product having contribution margin per unit $6.

The Spahr Company should go for purchasing the parts from outside supplier at $13.50 and use its facility to make another product.

Change in Operating Income = Increase by $7,500

Hope the above calculations, working and explanations are clear to you and help you in understanding the concept of question.... please rate my answer...in case any doubt, post a comment and I will try to resolve the doubt ASAP…thank you

Relevant Cost per unit

Direct materials

$2

Direct labor

$4

Variable Manufacturing Overhead

$3

Total Relevant Cost per unit

$9

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