RELEVANT COSTING EXAMPLES (INCREMENTAL APPROACH)
EXAMPLE 1 • Coleman Company owns a machine that produces a component for the products the company makes and sells. The company uses 1,800 units of this component in production each year. The costs of making one unit of this component are • Direct material: $7 • Variable manufacturing overhead: $6 • Direct labor: $4 • Fixed manufacturing overhead: $5 • The fixed overhead costs are unavoidable, and the unit cost is based on the present annual usage of 1,800 units of the component. An outside supplier has offered to sell Coleman this component for $18 per unit and can supply all the units it needs. • REQUIRED A. If Coleman buys the component from the outside supplier instead of making it, how much will net income change? Should Coleman make or buy the component? Use the incremental approach to justify your answer. B. Suppose Coleman could rent the machine to another company for $5,000 per year. How would your response change to part A? Use the incremental approach to justify your answer.
ANSWER TO EXAMPLE 1 A. Variable cost = $7 + $6 + $4 = $17 Incremental cost savings from not making component (1,800 x $17) $30600 Incremental cost of buying component (1,800 x $18) ($32400) Incremental decrease in net income due to buying component ($1800) Since net income decreases, Coleman should continue making the components. B. Incremental cost savings from not making component (1,800 x $17) $30600 Incremental annual rent from machine $5000 Incremental cost of buying component (1,800 x $18) ($32400) Incremental increase in net income due to buying component $3200 Since net income increases, the company should choose to buy the components.
EXAMPLE 2 • Tenchavez Company makes and sells 12,000 pairs of running shoes each year. The cost of making one pair of these shoes is: • Direct material $11 • Variable manufacturing overhead $5 • Direct labor $4 • Fixed manufacturing overhead $7 The fixed overhead costs are unavoidable. Tenchavez allocates fixed overhead costs based on its annual capacity of 15,000 pairs it is able to make. An overseas company recently offered to buy 3,000 pairs of shoes at $21 per pair. Regular customers buy shoes from Tenchavez at $30 per pair.
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