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Incremental Benefits and Effect of Alternative Use

Parsons Plumbing & Heating manufactures thermostats that it uses in several of its products. Management is considering whether to continue manufacturing the thermostats or to buy them from an outside source. The following information is available:

1. The company needs 80,000 thermostats per year. Thermostats can be purchased from an outside supplier at a cost of $6 per unit.

2. The cost of manufacturing thermostats is $7.50 per unit, computed as follows:

Direct materials $ 156,000
Direct labor 132,000
Manufacturing overhead:
Variable 168,000
Fixed 144,000

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Total manufacturing costs $ 600,000

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Cost per unit ($600,000 ÷ 80,000 units) $ 7.50

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3. Discontinuing the manufacture of the thermostats will eliminate all of the direct materials and direct labor costs but will eliminate only 60 percent of the variable overhead costs.

4. If the thermostats are purchased from an outside source, certain machinery used in the production process would no longer have to be leased. Accordingly, $9,200 of fixed overhead costs could be avoided. No other reductions will result from discontinuing production of the thermostats.

a. Prepare a schedule to determine the incremental cost or benefit of buying thermostats from the outside supplier. On the basis of this schedule, would you recommend that the company manufacture thermostats or buy them from the outside source? (Amounts to be deducted should be indicated with a minus sign. Omit the "$" sign in your response.)

Make the
Thermostats Buy the
Thermostats Incremental
Analysis
Manufacturing costs for 80,000 thermostats:
(Click to select)Notes payableRent payableDirect laborDirect materialsAccounts payable $ $
(Click to select)Notes payableSalesDirect laborDirect materialDepreciation expense
Manufacturing overhead:
(Click to select)CashDepreciation expenseVariableSalesAccounts receivable $
(Click to select)Depreciation expenseFixedSalesAccounts receivableCash
(Click to select)Rent payableInterest expenseCommon stockCost to salesCost to purchase

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Totals $ $ $

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b. Assume that if thermostats are purchased from the outside source, the factory space previously used to produce thermostats can be used to manufacture an additional 6,000 heat-flow regulators per year. These regulators have an estimated contribution margin of $18 per unit. The manufacture of the additional heat-flow regulators would have no effect on fixed overhead. Would this new assumption change your recommendation as to whether to make or buy thermostats? In support of your conclusion, prepare a schedule showing the incremental cost or benefit of buying thermostats from the outside source and using the factory space to produce additional heat-flow regulators. (Leave no cells blank - be certain to enter "0" wherever required. Amounts to be deducted should be indicated with a minus sign. Omit the "$" sign in your response.)

Effect of alternative use of factory space:
Incremental benefit (cost) of buying thermostats from outside source (see part a) $
Add: Contribution margin of alternative use of factory space

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Incremental benefit of buying thermostats from an outside source and using factory space to produce additional heat-flow regulators $.

Solution Preview

Part a:
Make the Thermostats Buy the Thermostats Incremental Benefits
Manufacturing costs for 80,000 thermostats:
Direct materials $ 156,000 0 +$156,000
Direct labor ...

Solution Summary

The solution discusses incremental benefits and the effect of alternative use.

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