Assume that factory space freed up by purchasing the part from an outside source can be used to manufacture another product that can be sold for $ profit. If Harvey Automobiles makes the part, what will its operating income be?

Complete Question:

Harvey Automobiles uses a standard part in the manufacture of several of its trucks. The cost of producing 40,000 parts is $130,000, which includes fixed costs of $70,000 and variable costs of $60,000. The company can buy the part from an outside supplier for $3 per unit, and avoid 30% of the fixed costs.

Assume that factory space freed up by purchasing the part from an outside source can be used to manufacture another product that can be sold for $13,000 profit. If Harvey Automobiles makes the part, what will its operating income be?

A. 156,000 greater than if the company bought the part

B. 26,000 less than if the company bought the part

C. 26,000 greater than if the company bought the part

D. 62,000 greater than if the company bought the part

Option C. 26,000 greater than if the company bought the part

Explanation:

Option A: In House manufacturing of 40,000 parts:

Variable Cost is always Relevant and is                             ($60,000)

The Fixed cost is always irrelevant unless it is specific fixed cost related to the decision. Hence Fixed cost is irrelevant here.

Option B: If we purchase from outsiders

The purchase cost of the product is variable cost hence it is relevant as it is always relevant.

Purchase Cost = $3 * 40,000 parts                                     ($120,000)

The decrease or increase in the cost or income, due to a decision is always relevant. The decrease in cost is Opportunity income or benefits and is given as under:

Decrease in Fixed cost by 30% = $70,000 * 30%               $21,000

Now the additional profit that will arise as we can manufacture additional parts of another Product B. This is only possible if we free factory space by purchasing parts of Product A from outsiders. This additional manufacturing of Product B parts will generate profit of $13,000 and thus is a relevant income here. It is also referred to as Opportunity Income.

Opportunity Income                                                                $13,000  

Total Relevant Cost                                                               ($86,000)

The cost of option A is lower from Option B by $26000 ($86000 - $60000). Hence the operating income would be higher by $26,000 if the company manufactures in-house rather purchasing 40,000 parts from outsiders.

Option C is correct option here.

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