Preston Industries, Inc. currently manufactures part QX100, which is used in several products produced by the company. Monthly production costs for 10,000 units of QX100 are as follows:Accounting has estimated that 20% of the fixed overhead costs currently assigned to QX100 would not be needed if the company chose to purchase the part from an outside supplier. Preston currently has the option of purchasing the part from an outside supplier at $16.00 per unit.
Based solely on a short-run financial analysis, the maximum price that Preston should be willing to pay the outside vendor for each unit of QX100 is:
A) $10.00
B) $11.00
C) $15.00
D) $15.80
E) $16.00

Question

Preston Industries, Inc. currently manufactures part QX100, which is used in several products produced by the company. Monthly production costs for 10,000 units of QX100 are as follows:Accounting has estimated that 20% of the fixed overhead costs currently assigned to QX100 would not be needed if the company chose to purchase the part from an outside supplier. Preston currently has the option of purchasing the part from an outside supplier at $16.00 per unit.
Based solely on a short-run financial analysis, the maximum price that Preston should be willing to pay the outside vendor for each unit of QX100 is:
A) $10.00 
B) $11.00 
C) $15.00 
D) $15.80 
E) $16.00

Quizplus · Accepted Answer

The relevant cost to consider in this decision is the incremental cost of producing versus purchasing the part from an outside supplier.

If Preston Industries decides to produce the part internally, the total cost per unit will be:

$3.00 (direct materials) + $4.00 (direct labor) + $6.00 (fixed overhead) x 0.8 (avoidable fixed overhead) = $10.80

If Preston Industries decides to purchase the part from an outside supplier, the cost per unit will be $16.00.

Therefore, the maximum price that Preston Industries should be willing to pay the outside vendor for each unit of QX100 is:

$10.80 (internal production cost) + $5.00 (maximum incremental cost) = $15.80

Any price higher than $15.80 would result in a loss for the company, making D the best choice.