“In my opinion, we ought to stop making our own drums and accept that outside supplier’s offer”, said Ahmad, managing director of Mega Forwarding. “At a price of RM16 per drum, we would be paying RM5.40 less than it costs to manufacture the drum in our own plant. Since we use 60,000 drums a year, that would be an annual operating cost saving of RM324,000”.
The following is cost to manufacture one drum (based on 60,000 drum per year).
|General company overhead||2.80|
|Total cost per drum||21.40|
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 exhausted and must be replaced. The choices of facing the company are:
(i) Purchase new equipment and continue to make the drums. The equipment would cost RM350,000; it would have a six-year useful life and no salvage value. The company uses straight-line depreciation.
(ii) Purchase the drums from an outside supplier at RM16 per drum under a six-year contract.
The new equipment would be more efficient than the equipment that Mega Forwarding has been using and, according to manufacturer, would reduce direct labour and variable overhead costs by 20 percent. The old equipment has no resale value. Supervision cost (RM45,000 per year) and direct material cost per drum would not be affected by the new equipment. The new equipment’s capacity would be 80,000 drums per year. The company has no other used to produce the drums. The company’s total general company overhead would be unaffected by this decision.
(a) Analyse both alternative courses of action and suggest which cost of action is preferable to the Managing Director. Provide computation of 60,000 drums to support your recommendation.
(b) Instead of sales of 60,000 drums, revised estimates show sales volume of 120,000 drums. At this new volume, additional equipment at an annual rental of RM400,000 must be acquired to manufacture the drums. Assuming that the outside supplier will not accept an order less than 120,000 drums, should Mega Forwarding make or buy the drums? Show computation to support your answer.
(c) Explain briefly any TWO (2) factors that the company considers before making a decision