P4–13 Make or buy analysis Time allowed: 45 minutes

‘In my opinion, we ought to stop making our own drums and accept that outside supplier’s offer,’ said Wim Niewindt, managing director of Antilles Refining NV of Aruba. ‘At a price of 18 florins per drum, we would be paying 5 florins less than it costs us to manufacture the drums in our own plant. (The currency in Aruba is the florin, denoted below by fl.) Since we use 60,000 drums a year, that would be an annual cost saving of 300,000 florins.’ Antilles Refining’s present cost to manufacture one drum is given below (based on 60,000 drums per year)

The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labour and variable overhead costs by 30%. The old equipment has no resale value. Supervision cost (fl45,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 90,000 drums per year. The company has no other use for the space being used to produce the drums.
The company’s total general company overhead would be unaffected by this decision.
Required 1 To assist the managing director in making a decision, prepare an analysis showing what the total cost and the cost per drum would be under each of the alternatives given above. Assume that 60,000 drums are needed each year. Which course of action would you recommend to the managing director?
2 Would your recommendation in Question 1 above be the same if the company’s needs were:

(a) 75,000 drums per year or

(b) 90,000 drums per year? Show computations to support your answer, with costs presented on both a total and a per unit basis.
3 What other factors would you recommend that the company consider before making a decision?

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Direct material f110.35 Direct labour 6.00 Variable overhead 1.50 Fixed overhead (f12.80 general company overhead, 11.60 depreciation and f10.75 5.15 supervision) Total cost per drum f123.00 A decision about whether to make or buy the drums is especially important at this time since the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are: Alternative 1 Alternative 2 Purchase new equipment and continue to make the drums. The equipment would cost $810,000; it would have a six-year useful life and no salvage value. The company uses straight-line depreciation. Purchase the drums from an outside supplier at fl18 per drum under a six-year contract.