SP Company makes 40,000 motors to be used in the production of its sewing machines. The average cost per motor at this level of activity is: $$\begin{array} { | l | l | }
\hline \text { Direct materials } & \$ 5.50 \
\hline \text { Direct labour } & \$ 5.60 \
\hline \text { Variable factory overhead } & \$ 4.75 \
\hline \text { Fixed factory overhead } & \$ 4.45 \
\hline
\end{array}$$ An outside supplier recently began producing a comparable motor that could be used in the sewing machine. The price offered to SP Company for this motor is $18. If SP Company decides not to make the motors, there would be no other use for the production facilities and total fixed factory overhead costs would not change. If SP Company
Decides to continue making the motor, how much higher or lower would net income be than if the motors are purchased from the outside suppler Assume that direct labour is a variable cost in this company.
A)$86,000 higher.
B)$276,000 higher.
C)$92,000 lower.
D)$178,000 higher.

Question

SP Company makes 40,000 motors to be used in the production of its sewing machines. The average cost per motor at this level of activity is: $$\begin{array} { | l | l | } 
\hline \text { Direct materials } & \$ 5.50 \
\hline \text { Direct labour } & \$ 5.60 \
\hline \text { Variable factory overhead } & \$ 4.75 \
\hline \text { Fixed factory overhead } & \$ 4.45 \
\hline
\end{array}$$ An outside supplier recently began producing a comparable motor that could be used in the sewing machine. The price offered to SP Company for this motor is $18. If SP Company decides not to make the motors, there would be no other use for the production facilities and total fixed factory overhead costs would not change. If SP Company
Decides to continue making the motor, how much higher or lower would net income be than if the motors are purchased from the outside suppler Assume that direct labour is a variable cost in this company.
A)$86,000 higher.
B)$276,000 higher.
C)$92,000 lower.
D)$178,000 higher.

Quizplus · Accepted Answer

The cost to produce one motor internally is the sum of direct materials, direct labor, variable factory overhead, and fixed factory overhead, which equals $5.50 + $5.60 + $4.75 + $4.45 = $20.30 per motor. The cost to purchase the motor from the outside supplier is $18 per motor. Therefore, by producing the motor internally, SP Company incurs an additional cost of $2.30 per motor ($20.30 - $18). For 40,000 motors, this additional cost totals $92,000 ($2.30 * 40,000). Thus, if SP Company decides to continue making the motor, net income would be $92,000 lower than if the motors are purchased from the outside supplier. However, the fixed factory overhead is a sunk cost and should not be considered in the decision to make or buy the motors. The relevant costs are direct materials, direct labor, and variable factory overhead, which total $15.85 ($5.50 + $5.60 + $4.75). Comparing this to the purchase price of $18, SP Company saves $2.15 per motor by making them in-house. For 40,000 motors, this saving amounts to $86,000 ($2.15 * 40,000), making net income $86,000 higher if the motors are made in-house rather than purchased.

SP Company Makes 40,000 Motors to Be Used in the Production