Blossom Water Co. is a leading producer of greenhouse irrigation systems. Curren
ID: 2564796 • Letter: B
Question
Blossom Water Co. is a leading producer of greenhouse irrigation systems. Currently, the company manufactures the timer unit used in each of its systems. Based on an annual production of 40,000 timers, the company has calculated the following unit costs. Direct fixed costs include supervisory and clerical salaries and equipment depreciation.
Clifton Clocks has offered to provide the timer units to Blossom at a price of $32 per unit. If Blossom accepts the offer, the current timer unit supervisory and clerical staff will be laid off.
Assume that if Blossom Water accepts Clifton’s offer, the company can use the freed-up manufacturing facilities to manufacture a new line of growing lights. The company estimates it can sell 80,000 of the new lights each year at a price of $10. Variable costs of the lights are expected to be $7 per unit. The timer unit supervisory and clerical staff would be transferred to this new product line. Calculate the total relevant cost to make the timer units and the net cost if they accept Clifton's offer.
Explanation / Answer
Blossom Water Co.
Calculation of the total relevant cost to make the timer units and the net cost if they accept Clifton’s offer:
Costs to make timer units –
Costs to MAKE the timer units:
Direct material
$11
Direct labor
$5
Variable manufacturing overhead
$2
Timer unit supervisory and clerical cost
$2.40
Total variable cost
$20.40
Notes:
The timer unit supervisory and clerical cost is calculated as follows,
Direct fixed manufacturing overhead = $8
Supervisory and clerical cost = 30% of $8 = $2.40
The remaining 70% is depreciation – since depreciation is an allocation and a sunk cost, the same is not relevant for calculation of total cost to MAKE.
The allocated fixed manufacturing overhead is an allocation of overall fixed costs and hence not a relevant cost.
Hence, the total cost to make a timer unit = $20.40
Total cost of producing 40,000 timer units = 40,000 x $20.40 = $816,000
Determination of relevant costs of BUY decision -
Price of timer unit = $32
Cost of buying 40,000 units = 40,000 x 32 = 1,280,000
Contribution margin from Use of freed-up manufacturing facilities –
Sales price = $10
Variable cost = $7
Contribution margin = $3
Less: cost of timer unit supervisory and clerical staff = $2.40
Net contribution = $3 - $2.40 = $0.60
Total contribution from use of freed-up facilities = 80,000 units x $0.60 = $48,000
Hence, the cost of buying = $1,280,000 - $48,000 = $1,232,000
Cost of making 40,000 timer units = $816,000
Cost of buying 40,000 timer units = $1,232,000
Excess cost of buying $416,000
Since net cost of buying ($416,000) is higher compared to cost of making $816,000, the company should MAKE the Timer units.
Costs to MAKE the timer units:
Direct material
$11
Direct labor
$5
Variable manufacturing overhead
$2
Timer unit supervisory and clerical cost
$2.40
Total variable cost
$20.40