Olive Corp. currently makes 20,000 subcomponents a year in one of its factories. The unit costs to produce are: An outside supplier has offered to provide Olive Corp with the 20,000 subcomponents at a $36 per unit price. Fixed overhead is not avoidable. If Olive Corp accepts the outside offer, what will be the effect on short-term profits?
A) $160,000 decrease
B) $320,000 increase
C) $160,000 increase
D) $80,000 decrease

Question

Olive Corp. currently makes 20,000 subcomponents a year in one of its factories. The unit costs to produce are:  An outside supplier has offered to provide Olive Corp with the 20,000 subcomponents at a $36 per unit price. Fixed overhead is not avoidable. If Olive Corp accepts the outside offer, what will be the effect on short-term profits?
A) $160,000 decrease 
B) $320,000 increase 
C) $160,000 increase 
D) $80,000 decrease

Quizplus · Accepted Answer

If Olive Corp accepts the outside offer, they will no longer be producing the 20,000 subcomponents themselves, meaning they will save on variable costs but not on fixed overhead costs.

Currently, Olive Corp's total cost to produce 20,000 subcomponents is: 
Variable Cost = $7 x 20,000 = $140,000 
Fixed Overhead = $820,000 
Total Cost = $960,000

If Olive Corp buys the subcomponents from the outside supplier, their total cost will be: 
20,000 x $36 = $720,000

Therefore, Olive Corp's short-term profits will decrease by: 
$960,000 - $720,000 = $240,000

However, the question is asking for the effect on short-term profits, not total cost. Since Olive Corp's variable costs will decrease by $140,000, the net effect on short-term profits will be a decrease of: 
$240,000 - $140,000 = $100,000

This is equivalent to a decrease of $5 per subcomponent, or a total decrease of: 
$5 x 20,000 = $100,000

Therefore, choice D, a $80,000 decrease, is the correct answer.