Question

Troy Engines, Ltd., manufactures a variety of engines for use in heavy equipment. The company has always produced all of the necessary parts for its engines, including all of the carburetors. An outside supplier has offered to sell one type of carburetor to Troy Engines, Ltd., for a cost of $35 per unit. To evaluate this offer, Troy Engines, Ltd. has gathered the following information relating to its own cost of producing the carburetor internally Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead, traceable Fixed manufacturing overhead, allocated Total cost 20.000 Per Units Unit Per Year $ 17 $ 340,000 11 220,000 3 60.000 3€ 60,000 6 120.000 $ 40 $ 800,000 *One-third supervisory salaries; two-thirds depreciation of special equipment (no resale value) Required: 1. Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 20,000 carburetors from the outside supplier? 2. Should the outside supplier's offer be accepted? 3. Suppose that if the carburetors were purchased, Troy Engines, Ltd., could use the freed capacity to launch a new product. The segment margin of the new product would be $200,000 per year. Given this new assumption, what would be the financial advantage (disadvantage) of buying 20,000 carburetors from the outside supplier? 4. Given the new assumption in requirement 3, should the outside supplier's offer be accepted? Complete this question by entering your answers in the tabs below. Required 1 Required 2 Required 3 Required 4 Assuming the company has no alternative use for the facilities that are now being used to produce the carburetors, what would be the financial advantage (disadvantage) of buying 20,000 carburetors from the outside supplier?

Answer 1

Solution:

In this type of question, the relevant cost is considered for decision making whether to make the product in house or buy from outside.

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

- Fixed Cost which is directly related to the alternative course of action.

The future costs which are different under each alternative course of action are called relevant cost. 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.

Sometimes there are some fixed costs which will directly associated with the production or increase production units and have characteristics of relevant cost. i.e. future cost and different under each alternative course of action. In this question special tool cost is this type of cost.

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 accept or reject the order. Hence it is treated as IRRELEVANT COST.

Note – Fixed manufacturing and selling costs are not considered relevant because these are fixed and not for the specific job. In decision making fixed costs are treated as period cost and not taken for decision making. Fixed Costs are irrelevant cost for decision making.

Note – Traceable fixed costs is considered relevant because they are traceable with the product directly and can be avoided if the product is not manufactured.

Part 1 – Financial advantage /(disadvantage) of buying 20,000 carburetors from outside supplier

Statement of Cost Analysis
	Whether Relevant or Irrelevant	Make	Buy
Direct materials	Relevant	$340,000	$0
Direct labor	Relevant	$220,000	$0
Variable manufacturing overhead	Relevant	$60,000	$0
Fixed manufacturing overhead, traceable	Relevant	$60,000	$0
Fixed manufacturing overhead, allocated	Irrelevant	$0	$0
Purchase Cost	Relevant		$700,000
Total Cost		$680,000	$700,000

Financial disadvantage of buying 20,000 carburetors from the outside supplier = $20,000

Because if the carburetors purchased from outside supplier, the total cost $700,000 that would be paid to supplier is higher than the cost of making the product $680,000 in house. Therefore there will be a LOSS of $20,000 if purchased from outside.

Part 2 – Outside supplier’s offer should NOT BE ACCEPTED

Part 3 –

Financial advantage of buying carburetor from the outside supplier = Increase in segment margin $200,000 – Opportunity Loss of making in house carburetor $20,000

= $180,000

Part 4 – Yes, the offer should be accepted.

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