"I think we should stop making our own barrels and accept this outside supplier's offer," said Wim Niewindt, general manager of Aruba's Antilles Refining, NV. “At a price of $20 per barrel, we pay $6.40 less than it would cost to produce the drums in our own factory. Since we use 65,000 drums per year, this translates to $416,000 annual cost savings.” The current cost of producing one barrel for Antilles Refining is given below (based on 65,000 barrels per year):

Direct materials	$	10.50
direct labor		8.00
variable load		2.00
Fixed overhead ($3.20 corporate overhead, $1.80 depreciation and $0.90 audit)		5.90
Total cost per drum	$	26.40

The decision as to whether to make the drums is particularly important at this time because the equipment used to make the drums is completely worn out and needs to be replaced. The options the company is facing include:

Alternative 1: Rent new equipment and keep drumming. The equipment was to be leased for $175,500 per year.

Alternative 2: Purchase the drums from an outside supplier for $20 per barrel.

The new equipment will be more efficient than the equipment Antilles Refining is currently using and will reduce direct labor and variable overheads by 35%, according to the manufacturer. Old equipment has no resale value. The inspection cost ($58,500 per year) and the direct material cost per drum will not be affected by the new equipment. The capacity of the new equipment will be 90,000 barrels per year.

The company's total general company overheads will not be affected by this decision.

Necessary:

1. Assuming 65,000 barrels are required each year, what is the financial advantage (disadvantage) of purchasing the drums from an outside supplier?

2. Assuming that 78,000 barrels are required each year, what is the financial advantage (disadvantage) of purchasing the drums from an outside supplier?

3. Assuming 90,000 barrels are required each year, what is the financial advantage (disadvantage) of purchasing the drums from an outside supplier?

Answer rating: 100% (QA)

To determine the financial advantage or disadvantage of purchasing the drums from an outside supplier we need to compare the costs of Alternative 1 re... View the full answer