The Wise Company manufactures a PT I Component that is used to make several of i

Question

The Wise Company manufactures a PT I Component that is used to make several of its products. The managerial accountant reported monthly production costs to produce 1,100 units of PT I Component included:

Direct materials

$22,000

Direct labor

5,100

Variable overhead costs

15,050

Fixed overhead costs

10,050

The managerial accountant estimates that 10% of the fixed overhead costs assigned to PT I Component will no longer be incurred if the company purchases the PT I Component from an outside supplier at $41.50 per unit.

If the manager at Wise Company accepts the offer from the outside supplier, what are the monthly avoidable costs, or those costs that will no longer be incurred? What is the monthly operating income if the manager at Wise Company purchases 1,000 units of PT I Component from an outside supplier? What is the maximum

Direct materials

$22,000

Direct labor

5,100

Variable overhead costs

15,050

Fixed overhead costs

10,050

Explanation / Answer

Solution:

The question is related to the decision making with regard to the buy product from outside supplier. It involves analysis of the cost of manufacturing the product and the purchase price offered by the outside customer.

In this type of question relevant cost plays a very important role for decision making.

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 Cost of Goods Sold

- 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. Hence it is treated as IRRELEVANT COST.

In this question, direct material, direct labor and variable overhead costs are the cost which is relevant. Hence these costs will not incur if the company purchase the product from outside supplier.

Fixed Overhead which is relevant with the product is relevant but it is sunk cost which has already been incurred. Hence it will incur whether company purchase the product from outside or make the product in house.

Now, we will answer the questions asked:

Part 1 --- what are the monthly avoidable costs, or those costs that will no longer be incurred?

The cost that will not incur as follows:

Monthly Avoidable Cost

Direct Material

$22,000

Direct Labor

$5,100

Variable overhead Costs

$15,050

Fixed Overhead Costs (directly associated with the PT I Component) ($10,050*10%)

$1,005

Total Monthly Avoidable Cost

$43,155

Part 2 -- What is the monthly operating income if the manager at Wise Company purchases 1,000 units of PT I Component from an outside supplier?

Monthly Avoidable Cost (1100 Units)

Per Unit Cost (Cost / 1100 Units)

Making Cost for 1,000 Units

Direct Material

$22,000

$20.0000

$20,000

Direct Labor

$5,100

$4.6364

$4,636

Variable overhead Costs

$15,050

$13.6818

$13,682

Fixed Overhead Costs (directly associated with the PT I Component) ($10,050*10%)

$1,005

Total Monthly Avoidable Cost

$43,155

$38,318

Statement of Effect on Operating Income if company buy product from outside supplier

Making Cost for 1,000 Units

Buy Product From Outside

Net Increase or (Decrease) on Operating Income

Direct Material

$20,000

$20,000

Direct Labor

$4,636

$4,636

Variable overhead Costs

$13,682

$13,682

Fixed Overhead Costs

$1,005

$1,005

Purchase Price offered by outside supplier (1,000 Units x 41.50)

41500

-$41,500

Increase / (Decrease) in Operating Profit

$39,323

$41,500

-$2,177

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

Monthly Avoidable Cost

Direct Material

$22,000

Direct Labor

$5,100

Variable overhead Costs

$15,050

Fixed Overhead Costs (directly associated with the PT I Component) ($10,050*10%)

$1,005

Total Monthly Avoidable Cost

$43,155

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