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P is considering whether 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:
$/unit
Direct materials 3.00
Direct labour 4.00
Variable overhead 1.00
Specific fixed cost 2.50
Other fixed costs 2.00
–––––
12.50
–––––
If 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 $10.00 per unit but requires $8.00 of labour per unit.
What is the maximum price per component, at which buying is preferable to internal
manufacture?What is the maximum price per component, at which buying is preferable to internal
manufacture?
The answer here is 15.50.
-What I don’t understand is why is the maximum price for buying is higher than what the internal cost of making it. This answer did not make sense to me. Is it correct?Because it asks
What is the “maximum” price per component, at which buying is preferable to internal manufacture?
The relevant cost of making internally (and therefore the maximum price at which buying externally is preferable) is the total of the variable costs and the specific fixed cost, replying the labour cost ($4) with the labour cost plus the lost contribution per unit.
Direct material 3.00
Direct labor (W1) 9.00
Variable overhead 1.00
Specific fixed cost 2.50
15.50Again
(W1) Relevant cost = Contribution Forgone + Direct labour = $10/2 + $4 = $9
The new item requires only half as much labour as the other item (the labour is only $4 as against $8). So every new item made loses 1/2 another item.
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