Drums and accept that outside supplier

Reference no: EM131812753

"In my opinion, we ought to stop making our own drums and accept that outside supplier's offer," said Wim Niewindt, managing director of Antilles Refining, N.V., of Aruba. "At a price of 36 florins per drum, we would be paying 10 florins less than it costs us to manufacture the drums in our own plant. (The currency in Aruba is the florin, denoted by Afl.) Since we use 120,000 drums a year, that would be an annual cost savings of 1,200,000 florins." Antilles Refining's present cost to manufacture one drum follows (based on 120,000 drums per year):

140_present cost to manufacture one drum.jpg

A decision about whether to make or buy the drums is especially important at this time, since the equipment being used to make the drums is completely worn out and must be replaced. The choices facing the company are as follows:

Alternative 1: Purchase new equipment and continue to make the drums. The equipment would cost Afl1,620,000; it would have a six-year useful life and no salvage value. The company uses straight-line depreciation.

Alternative 2: Purchase the drums from an outside supplier at Afl36 per drum under a six-year contract.

The new equipment would be more efficient than the equipment that Antilles Refining has been using and, according to the manufacturer, would reduce direct labour and variable overhead costs by 30%. The old equipment has no resale value. Supervision cost (Afl180,000 per year) and direct materials cost per drum would not be affected by the new equipment. The new equipment's capacity would be 180,000 drums per year. The company has no other use for the space being used to produce the drums.

The company's total general company overhead would be unaffected by this decision.

Required:

1. To assist the managing director in making a decision, prepare an analysis showing the total cost and the cost per drum under each of the two alternatives stated previously. Assume that 120,000 drums are needed each year. Which course of action would you recommend to the managing director?

2. Would your recommendation in part (1) be the same if the company's needs were (a) 150,000 drums per year? (b) 180,000 drums per year? Show computations to support your answer, with costs presented on both a total and a per-unit basis.

Direct material. Direct labour Variable overhead Fixed overhead (Afl5.60 general company overhead, Af13.20 depreciation, and Afl 50 supervision) Total cost per drum Afl20.70 12.00 3.00 10.30 Afl 46.00

Reference no: EM131812753

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