A vacuum manufacturer has prepared the following cost data for manufacturing one of its engine components based on the annual production of 50,000 units. Description Cost per Month
Direct Materials $75,000
Direct Labor $100,000
Total $175,000
In addition, variable factory overhead is applied at $7.50 per unit. Fixed factory overhead is applied at 150% of direct labor cost per unit. The vacuums sell for $150 each. A third party has offered to make the engines for $60 per unit. 75% of fixed factory overhead, which represents executive salaries, rent, depreciation, and taxes, continue regardless of the decision. Should the company make or buy the engines?

Make or Buy Decisions:

a) Make (50,000 units)

Direct materials           $75,000

Direct labor                  100,000

Variable overhead      375,000

Total variable costs  $550,000

Contribution          $6,950,000

Sales                      $7,500,000

Fixed overhead          150,000

Net profit              $7,350,000

b) Buy (50,000):

Purchase price    $3,000,000

Contribution        $4,500,000

Fixed costs                 112,500

Net profit             $4,387,500

c) The company should make the engines.

Explanation:

a) Variable overhead = $375,000 ($7.50 x 50,000)

b) Fixed overhead = $150,000 ($100,000 x 1.5)

c) Sales = $7,500,000 ($150 x 50,000)

d) Purchase = $3,000,000 ($60 x 50,000)

e) Unavoidable Fixed overhead = $112,500 ($150,000 x 75%)

f) The problem is called a make or buy decision because, management of this company is faced with two options.  In order to arrive at the better option in terms of long-term financial implication, the costs and profitability of the decision must be taken into consideration.  Relevant costs are considered.  A look at the two options, clearly shows that it makes better financial sense for the company to make than to buy the engines outside.  Therefore, management is advised to make as the company will make much more sustainable profit by so doing.

rational decision making is a multi-step process for making choices between alternatives. the process of rational decision making favors logic, objectivity, and analysis over subjectivity and insight. the word “rational” in this context does not mean sane or clear-headed as it does in the colloquial sense.

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