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Hello Sir,
Please could you help me to understand the following question, from Kaplan Revision Kit;
P is considering if to continue making a component or to buy it from an outside supplier. It uses 12,000 of the components each year.
The internal manufacturing cost comprises:
Direct mat – $3 per unit
Direct lab – $4 per unit
Variable o/h – $1 per unit
Specific Fixed costs-$2.50 per unit
Other Fixed costs- $2.00 per unitIf the direct labour were not used to manufacture the component, it would be used to increase the production of another item for which there is unlimited demand. This other item has a contribution of $10 per unit but requires $8 of labour per unit.
What is the maximum price per component, at which buying is preferable to internal manufacture?a) $8
b) $10.50
c) $12.50
d) $15.50Thank you
LeoIf they buy the component from outside, they will save the cost of material, the variable overheads, and the specific fixed costs (they will not save on labour because the will be using it to produce something else, and they will not save on ‘other’ fixed costs because they will still be incurred). So they will be saving $6.50 per component.
In addition, because the will use the labour to produce another item they will earn contribution of $10 from the other item. However this other item uses twice as much labour, so for every one component bought from outside instead of being made, they will be earning a contribution of $5 from this other item.
Therefore in total they will gain 6.50 + 5 = $11.50 and therefore this is the maximum they will be prepared to pay to buy from outside.
Thank you for the reply. I am still a little bit not clear on how we get to the $5 “so for every one component bought from outside instead of being made, they will be earning a contribution of $5 from this other item”.
In addition I am trying to reconcile why Kaplan is saying that the answer is $15.50…
Thank you
Sorry, the answer is indeed $15.50. The extra $4 is the cost of the labour.
The reason the contribution is $5 is that because the labour cost of the other unit is $8 and the labour cost of making the component is only $4 it means that the other unit must be taking twice as long to make as does the component. So every hour taken away from the component lets them make half a unit of the other unit.
To explain why the labour is relevant. Imagine this – suppose the other unit has a selling price of $20, a labour cost of $8 and other variable costs (e.g. materials) if $2. So the contribution is $10. They will be paying the labour whether or not they move the labour to this other unit, so the benefit is the revenue of $20 less the other variable costs of $2, which is $18. This is the same (and is always the same) and the contribution ($10) plus the labour ($8). But only half of it is relevant because of what I write in the previous paragraph.
Sorry for the confusion before 🙁
Much clearer now. Thank you for explanation, I didn’t find i
This question straightforward.
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