PROBLEM 7-28 Make or Buy Analysis [LO 7-3] "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, N.V., of Aruba. "At a price of $18 per drum, we would be paying $5 less than it costs us to manufacture the drums in our own plant. Since we use 60,000 drums a year, that would be an annual cost savings of $300,000." Antilles Refining's current cost to manufacture one drum is given below (based on 60,000 drums per year): Differential Analysis: The key to Decision Making $10.35 6.00 1.50 Direct materials...... Direct labor... Variable overhead .... Fixed overhead ($2.80 general company overhead, $1.60 depreciation and, $0.75 supervision)....... Total cost per drum ..... 5.15 $23.00 A decision about whether to make or buy the drums is especially important at this time because the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are: Alternative l: Rent new equipment and continue to make the drums. The equipment would be rented for $135,000 per year. Alternative 2: Purchase the drums from an outside supplier at $18 per drum. The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labor and variable overhead costs by 30%. The old equipment has no resale value. Supervision cost ($45,000 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'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 the total cost and the cost per drum for each of the two 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 requirement 1 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? P7-28 Requirement 1. Differential Costs per Total Differential Cost Drum for 60,000 Drums Make Buy Make Buy $ $ - S S - - Outside supplier's price: Direct Materials: Direct Labor: Variable Overhead: Supervision: Equipment Rental: Total Costs Difference $ . - S - $ S $ - - $ $ Recommendation - Make or Buy? Why? Requirement 2 a.) Differential Costs per Total Differential Cost Drum for 75,000 Drums Make Buy Make Buy $ - Outside supplier's price: Direct Materials: Direct Labor: Variable Overhead: Supervision: Equipment Rental: Total Costs Difference $ $ $ $ - . . . S . - $ - $ - $ $ - . $ $ Recommendation - Make or Buy? Why? b.) Differential Costs per Total Differential Cost Drum for 90,000 Drums Make Buy Make Buy $ - $ - Outside supplier's price: Direct Materials: Direct Labor: Variable Overhead: Supervision: Equipment Rental: Total Costs Difference - $ - $ $ $ - - $ $ - - Recommendation - Make or Buy? Why? Requirement 3. Write your answer to Requirement 3 below (HINT: 8 potential options)
