Determine the Incremental Cost
A company currently makes a component that has the given unit cost structure
|
Direct Material
|
Shs. 100
|
|
Direct Wages
|
Shs. 200
|
|
Variable overhead
|
Shs. 50
|
|
Fixed Overhead
|
Shs. 140
|
|
Total
|
Shs. 490
|
Required
Advice management whether the component must be bought in from an outside company for Shs. 330 per unit
Solution
1. The net cost of manufacture of the component is Shs. 490 per unit
2. The apparent saving via buying in the component is Shs. (490 - 330) = 160
3. If the fixed overhead cost is an apportionment of the company fixed overhead that will be ignorable if production is discontinued, the relevant cost of manufacture is Shs. 350. This supposes that the direct material and variable overheads and direct wages are all directly variable along with the production of the component. It still leaves the purchase of the component for Shs. 330 a cheaper alternative than manufacture at a relevant cost of Shs. 350
4. Other factors that are non quantifiable in short term must be considered nevertheless before a final decision is made
a) Will the quality of the bought in component be as acceptable as like manufactured internally?
b) Will the outside supplier be capable to supply the components as desired or will there be production delays since of late delivery?
c) Will there be industrial relations difficulty due to the loss of jobs via workers who currently make the component?
5. Further analysis of the solution may reveal such the production capacity currently employed to make the component could be employed as an alternative manufacturing opportunity that could be sold externally and yield a contribution equivalent of Shs. 50 for every component it replaces.