Q.22 Karbon Corporation uses part B76 in one of its products. The company’s Accounting Department reports the following costs of producing the 12,000 units of the part that are needed every year.
Direct Materials $8.20
Direct Labour $6.10
Variable Overhead $3.50
Production Supervisor’s salary $4.70
Depreciation on Equipment $3.40
Allocated general overhead $2.40
An outside supplier has offered to make the part and sell it to the company for $27.40 each. If this offer is accepted, the supervisor’s salary and all of the variable costs, including direct labour, can be avoided. The equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents the fixed costs of the entire company. If the outside supplier’s offer were accepted, only $6,000 of these allocated general overhead costs would be avoided. In addition, the space used to produce part B76 could be rented out generating an additional income of $29,000 per year.
Required:
a. Make a report that shows the effect on the company’s total net operating income of buying part B76 from the supplier rather than continuing to make it inside the company. [7 Marks]
b. Which alternative should the company choose, make or Buy? Why? [2 Marks]
In today’s competitive business landscape, companies are constantly seeking ways to optimize their operations and enhance their bottom line. Karbon Corporation faces a crucial decision regarding its product, Part B76, and whether to continue manufacturing it internally or to procure it from an outside supplier. This report will delve into the financial implications of both options, considering direct costs, overheads, and potential additional revenues.
Effect on Net Operating Income
Internal Production Costs:
Direct Materials: $8.20 × 12,000 units = $98,400
Direct Labour: $6.10 × 12,000 units = $73,200
Variable Overhead: $3.50 × 12,000 units = $42,000
Production Supervisor’s Salary: $4.70 × 12,000 units = $56,400
Depreciation on Equipment: $3.40 × 12,000 units = $40,800
Allocated General Overhead (Avoidable): $2.40 × 12,000 units = $28,800
Total Internal Production Costs: $339,600
Additional Costs and Revenues
Avoided Allocated General Overhead: $6,000
Additional Income from Rented Space: $29,000
Net Effect of Additional Costs/Revenues: $6,000 + $29,000 = $35,000
Total Cost of Internal Production
Total Production Costs – Additional Revenues: $339,600 – $35,000 = $304,600
Comparison and Recommendation
The outside supplier offers Part B76 at a unit price of $27.40, which needs to be contrasted with the cost of internal production, including avoidable costs and potential revenues. Calculations indicate that the total cost of producing the part internally amounts to $304,600, whereas the outside supplier’s cost is $27.40 × 12,000 units = $328,800.
Therefore, if Karbon Corporation chooses to outsource the manufacturing of Part B76 to the external supplier, it would result in an increase in costs by $24,200 ($328,800 – $304,600).
Conclusion
In light of the analysis conducted, it is evident that continuing to manufacture Part B76 internally is the more financially prudent option for Karbon Corporation. Despite the potential to avoid some allocated general overhead and generate additional revenue from renting out space, the cost of procuring the part from the outside supplier outweighs these benefits. By producing Part B76 internally, the company can maintain a lower total net operating income and retain better control over the quality and production process.
In conclusion, Karbon Corporation should choose to “make” Part B76 instead of “buying” it from the outside supplier, given the cost considerations and potential impact on net operating income. This decision aligns with the company’s commitment to optimizing its operations and sustaining its competitive edge in the market.
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