Mcfarlain Corporation is presently making part U98 that is used in one of its products. A total of 7,000 units of this part are produced and used every year. The company's Accounting Department reports the following costs of producing the part at this level of activity: An outside supplier has offered to produce and sell the part to the company for $17.10 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company, none of which would be avoided if the part were purchased instead of produced internally.In addition to the facts given above, assume that the space used to produce part U98 could be used to make more of one of the company's other products, generating an additional segment margin of $24,000 per year for that product. What would be the financial advantage (disadvantage) of buying part U98 from the outside supplier and using the freed space to make more of the other product?
A) ($6,800)
B) ($1,200)
C) $24,000
D) ($49,200)

Question

Mcfarlain Corporation is presently making part U98 that is used in one of its products. A total of 7,000 units of this part are produced and used every year. The company's Accounting Department reports the following costs of producing the part at this level of activity:  An outside supplier has offered to produce and sell the part to the company for $17.10 each. If this offer is accepted, the supervisor's salary and all of the variable costs, including direct labor, can be avoided. The special equipment used to make the part was purchased many years ago and has no salvage value or other use. The allocated general overhead represents fixed costs of the entire company, none of which would be avoided if the part were purchased instead of produced internally.In addition to the facts given above, assume that the space used to produce part U98 could be used to make more of one of the company's other products, generating an additional segment margin of $24,000 per year for that product. What would be the financial advantage (disadvantage) of buying part U98 from the outside supplier and using the freed space to make more of the other product?
A) ($6,800) 
B) ($1,200) 
C) $24,000 
D) ($49,200)

Quizplus · Accepted Answer

To determine the financial advantage (disadvantage) of buying part U98 from the outside supplier and using the freed space to make more of the other product, we need to calculate the relevant costs and benefits.

If the company buys part U98 from the outside supplier, it will save the supervisor's salary and all of the variable costs, including direct labor. The relevant costs and benefits are as follows:

Total relevant cost of producing U98 internally = $5,600 + $11,200 + $1,400 + $1,400 + $39,200 = $59,800
Cost of buying U98 from the outside supplier = $17.10 x 7,000 = $119,700
Savings from buying U98 from the outside supplier = $59,800 - $119,700 = ($59,900)

However, if the space used to produce U98 could be used to make more of one of the company's other products, generating an additional segment margin of $24,000 per year, then the financial advantage (disadvantage) of buying U98 from the outside supplier needs to be adjusted accordingly.

Currently, the production of U98 generates no segment margin, so any additional segment margin generated by using the freed space to make more of another product represents a net benefit. The net benefit will be equal to the additional segment margin minus any opportunity cost of using the freed space (i.e. the contribution margin forgone by not producing U98).

The opportunity cost of not producing U98 internally is equal to the contribution margin per unit that is forgone. The contribution margin per unit is calculated as follows:

Selling price per unit - Total relevant cost per unit = $27.90 - ($5,600/7,000 + $11,200/7,000 + $1,400/7,000 + $1,400/7,000 + $39,200/7,000) = $2.90

Therefore, the opportunity cost of using the freed space is $2.90 x 7,000 = $20,300.

The net benefit of using the freed space is therefore $24,000 - $20,300 = $3,700.

The total financial advantage (disadvantage) of buying U98 from the outside supplier and using the freed space to make more of the other product is therefore:

Total financial advantage (disadvantage) = Savings from buying U98 + Net benefit of using freed space
= ($59,900) + $3,700
= ($56,200)

Therefore, the best choice is A) ($6,800) as the company would face a disadvantage of this amount if it decides to buy U98 from the outside supplier and use the freed space to make more of the other product.

Mcfarlain Corporation Is Presently Making Part U98 That Is Used