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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
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?– The answer is $15.50
-In the book it says “Relevant cost = Contribution Forgone + Direct labour = $10/2 + $4 = $9”
-Could you explain the logic of this calculation of relevant cost?Thanks.
Every unit of the component costs $4 in labour.
If instead the produced the other item, the labour cost would be $8, and so the other item must take twice as long to produce.
So for every 2 units of the component they could instead make 1 unit of the other item. This 1 unit would have given contribution of $10, so the lost contribution for every 1 unit of the component is $10/2. We then add this to the labour cost of the component of $4 for the same reasons as I have explained to you before.
Producing the other item for which there is unlimited demand would give a contribution of $10 but would take two times as much labour as the component in question.
Therefore for every 2 units of the component in question that we were to make would lose $10 we could have made from other other item for which there is unlimited demand.
If 2 units loses $10, then 1 unit loses 10/2 = $5
Thank you so much sir, I now understand it Alhumdulillah!! How did the answer come to be $15.5?? Is it by adding $3 of direct material, $1 of variable O/H and $2.5 of specific fixed cost to the $9 that you had found earlier??
Sorry but I haven’t come across a question like this in my BPP kit so it’s confusing as there’s relevant costing+make or buy decision in it. In my BPP textbook on page 170, it’s written that the relevant costs are the differeriant costs between making and buying, so to my understanding, if the unit variable cost of making is 14 and the unit variable cost of buying is 12 then the relevant cost is 2 in this case??
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