Damon Industries manufactures 30,000 components per year. The manufacturing costs of the components was determined as follows:

Direct materials $ 150,000
Direct labor 170,000
Variable manufacturing overhead 70,000
Fixed manufacturing overhead 90,000

An outside supplier has offered to sell the component for $14. If Damon purchases the component from the outside supplier, the manufacturing facilities would be unused and could be rented out for $11,000. If Damon purchases the component from the supplier instead of manufacturing it, the effect on operating profits would be a:
a. $19,000 decrease
b. $41,000 increase
c. $49,000 decrease
d. $89,000 increase

The correct answer is:

$19,000 decrease (a)

Explanation:

To calculate this, we have to calculate the total cost involved, when the product was manufactured and when it was purchased and calculate the difference in cost.

Note also that when calculating cost for manufacturing, you do not add fixed overhead costs because they are not costs associated with the direct manufacture of a product, rather, they are costs associated with the day to day running of the business, example here may be the electricity used in the factory.

Total manufacturing cost ($);

Direct materials =           150,000

Direct labor        =           170,000  

variable overhead =         70,000

Total                   =           $390,000

Total purchase cost ($)

1 component = $14

∴ 30,000 components = 30,000 × 14 = 420,000

if the facilities are rented out for $11,000, Damon could use the money for the purchase too, therefore effective cost for purchase;

= 420,000 - 11, 0000 = $409,000.

Now finding the difference between the two costs;

cost of purchase       = $ 409,000

Cost of manufacture = $ 390,000

difference                  = $19,000

since the cost of purchase of the components is more than the cost of manufacturing by $19,000, it means that the operating profits will reduce by  $19,000 if Damon chooses to purchase the components

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