Cotton Corp.currently makes 10,000 subcomponents a year in one of its factories.The unit costs to produce are: An outside supplier has offered to provide Cotton Corp with the 10,000 subcomponents at an $84.50 per unit price.Fixed overhead is not avoidable.If Cotton Corp.accepts the outside offer,what will be the effect on short-term profits?
A)$260,000 increase
B)$195,000 decrease
C)no change
D)$65,000 increase

Question

Cotton Corp.currently makes 10,000 subcomponents a year in one of its factories.The unit costs to produce are:  An outside supplier has offered to provide Cotton Corp with the 10,000 subcomponents at an $84.50 per unit price.Fixed overhead is not avoidable.If Cotton Corp.accepts the outside offer,what will be the effect on short-term profits?
A)$260,000 increase 
B)$195,000 decrease 
C)no change 
D)$65,000 increase

Quizplus · Accepted Answer

To calculate the savings of outsourcing, we need to find the total cost of production internally and compare it with the cost of purchasing the subcomponents from the outside supplier.

Total cost of production internally = (10,000 units x $154.50) + fixed overhead 
= $1,545,000 + fixed overhead

Total cost of purchasing from outside supplier = (10,000 units x $84.50) + fixed overhead 
= $845,000 + fixed overhead

Since fixed overhead costs are the same in both cases, the difference in cost is 
= $1,545,000 + fixed overhead - ($845,000 + fixed overhead) 
= $700,000

This means that outsourcing will save Cotton Corp $700,000 in the short term. Therefore, the effect on short-term profits will be a decrease of $195,000 (before tax), since the fixed overhead is not avoidable.

Thus, the best choice is B.