Han Products manufactures 39,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is:

Han Products manufactures 39,000 units of part S-6 each year for use on its production line. At this level of activity, the cost per unit for part S-6 is:

Direct materials	$	3.20
Direct labor		11.00
Variable manufacturing overhead		2.80
Fixed manufacturing overhead		12.00
Total cost per part	$	29.00

An outside supplier has offered to sell 39,000 units of part S-6 each year to Han Products for $23 per part. If Han Products accepts this offer, the facilities now being used to manufacture part S-6 could be rented to another company at an annual rental of $89,000. However, Han Products has determined that two-thirds of the fixed manufacturing overhead being applied to part S-6 would continue even if part S-6 were purchased from the outside supplier.

Required:

What is the financial advantage (disadvantage) of accepting the outside supplier’s offer?

Explanation

The costs that can be avoided as a result of purchasing from the outside are relevant in a make-or-buy decision. The analysis is:

	Per unit Differential Costs							39,000 Units
	Make			Buy				Make			Buy
Cost of purchasing				$	23						$	897,000
Cost of making:
Direct materials	$	3.20						$	124,800
Direct labor		11.00							429,000
Variable overhead		2.80							109,200
Fixed overhead		4.00	*						156,000
Total cost	$	21.00		$	23.00			$	819,000		$	897,000

* The remaining $8 of fixed overhead cost ($12.00 per unit × 2/3 = $8 per unit) would not be relevant, because it will continue regardless of whether the company makes or buys the parts.

The $89,000 rental value of the space being used to produce part S-6 is an opportunity cost of continuing to produce the part internally. Thus, the complete analysis is:

	Make			Buy
Total cost, as above	$	819,000		$	897,000
Rental value of the space (opportunity cost)		89,000
Total cost, including opportunity cost	$	908,000		$	897,000
Financial advantage accepting the outside supplier’s offer	$			11,000

The company would be $11,000 better off if it accepted the outside supplier’s offer.

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