Knaack Corporation is presently making part R20 that is used in one of its products. A total of 18,000 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 $27.70 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 R20 could be used to make more of one of the company's other products,generating an additional segment margin of $27,000 per year for that product.What would be the impact on the company's overall net operating income of buying part R20 from the outside supplier and using the freed space to make more of the other product?
A)Net operating income would increase by $27,000 per year.
B)Net operating income would decline by $135,000 per year.
C)Net operating income would decline by $23,400 per year.
D)Net operating income would decline by $189,000 per year.

Question

Knaack Corporation is presently making part R20 that is used in one of its products. A total of 18,000 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 $27.70 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 R20 could be used to make more of one of the company's other products,generating an additional segment margin of $27,000 per year for that product.What would be the impact on the company's overall net operating income of buying part R20 from the outside supplier and using the freed space to make more of the other product?
A)Net operating income would increase by $27,000 per year. 
B)Net operating income would decline by $135,000 per year. 
C)Net operating income would decline by $23,400 per year. 
D)Net operating income would decline by $189,000 per year.

Quizplus · Accepted Answer

Firstly, let's calculate the segment margin lost by discontinuing the production of R20:

Segment margin lost by discontinuing R20 = Sales revenue - Variable costs - Traceable fixed costs = $120,000 - $70,000 - $20,000 = $30,000 per year

Now, if the freed-up space is used to make more of the other product, the segment margin generated would be $27,000 per year.

So, the net effect on the company's overall net operating income would be:

Net impact on operating income = Segment margin lost by discontinuing R20 + Segment margin gained from other product = $30,000 - $27,600 = $2,400 per year

Therefore, the net operating income would decline by $2,400 per year.

Option C is the closest answer as it is the only option that represents a decline in net operating income.

Knaack Corporation Is Presently Making Part R20 That Is Used