Outram Corporation is presently making part I14 that is used in one of its products. A total of 8,000 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 make and sell the part to the company for $14.80 each. If this offer is accepted, the supervisor's salary and all of the variable costs 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. If management decides to buy part I14 from the outside supplier rather than to continue making the part, what would be the annual impact on the company's overall net operating income?
A) Net operating income would decline by $15,200 per year.
B) Net operating income would increase by $15,200 per year.
C) Net operating income would increase by $52,800 per year.
D) Net operating income would decline by $52,800 per year.

Question

Outram Corporation is presently making part I14 that is used in one of its products. A total of 8,000 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 make and sell the part to the company for $14.80 each. If this offer is accepted, the supervisor's salary and all of the variable costs 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. If management decides to buy part I14 from the outside supplier rather than to continue making the part, what would be the annual impact on the company's overall net operating income?
A) Net operating income would decline by $15,200 per year. 
B) Net operating income would increase by $15,200 per year. 
C) Net operating income would increase by $52,800 per year. 
D) Net operating income would decline by $52,800 per year.

Quizplus · Accepted Answer

Current cost of producing 8,000 units internally:
Direct materials = $14.80 x 8,000 = $118,400
Direct labor = $7.50 x 8,000 = $60,000
Variable overhead = $2.00 x 8,000 = $16,000
Supervisor's salary = $20,000
Allocated fixed overhead = $80,000
Total cost = $294,400

Cost of buying 8,000 units from outside supplier:
$14.80 x 8,000 = $118,400

Net operating income impact:
$294,400 - $118,400 = $176,000 decrease in net operating income

However, if the company decides to buy the part from the outside supplier, the supervisor's salary ($20,000) and variable costs ($16,000) can be avoided. Therefore, the annual impact on net operating income would be a decline of $15,200 ($176,000 - $20,000 - $16,000 = $140,800) if the company decides to buy the part from the outside supplier.

Outram Corporation Is Presently Making Part I14 That Is Used