Vacuum Manufacturer Case Study

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Different revenues and costs represent the difference in revenues and costs between alternative options for action. The analysis of this difference is called differential analysis. Differential analysis is useful in making managerial decisions related to the manufacture or purchase of products, the maintenance or elimination of product lines, the retention or elimination of customers, and the acceptance or rejection of special customer orders (Heisinger & Hoyle, n.d).

Case Study: Vacuum Manufacturer

A vacuum manufacturer has prepared the following cost data for manufacturing one of its engine components based on the annual production of 50,000 units.

• Direct Materials = $75,000/month = 12*$75,000/month = $900,000
• Direct Labor = $100,000/month = 12*$100,000/month = $1,200,000
• Total = $175,000/month
• Variable factory overhead = $7.50/unit
• Fixed factory overhead = 150% of direct labor cost per unit.
• Vacuums sales price = $150 each.
• A third party has offered to make the engines for $60 per unit. 75% of fixed factory overhead, which represents executive salaries, rent, depreciation, and taxes, continues regardless of the decision.

Differential Analysis Calculation (see the detailed calculation on the Excel file attached to this assignment)

Cost if the company choose to make their own engines:

1. Total annual direct materials/unit =Annual direct materials ($900,000) / annual production (50000 unit) = $18/unit
2. Total annual direct labor = Annual direct labor ($1,200,000) / annual production (50000 unit) = $24/unit
3. From the data given we know that Variable factory overhead = $7.5/unit
4. From the data given we know that Fixed factory overhead = 150% * direct labor cost per unit ($24/unit) = $36/unit
5. Total annual production cost if the company choose to make their own engines = $18/unit + $24/unit + $7.5/unit + $36/unit = $85.5/unit

Cost if the company chooses to buy the engines from a third party:

1. Total annual direct materials/unit = $0 (since the company doesn’t need this)
2. Total annual direct labor = $0 (since the company doesn’t need this)
3. Variable factory overhead = $0 (since the company doesn’t need this)
4. The engine price = $60/unit
5. Fixed factory overhead = $27/unit
6. Total annual production cost if the company chooses to buy engines from 3rd party = $60/unit + $27/unit = $87/unit

Total Annual Differential Cost

Total differential cost/unit = Total annual production cost if the company chooses to make their own engines ($85.5/unit) — Total annual production cost if the company chooses to buy engines from 3rd party ($87/unit) = -$1.5/unit

Annual production = 50000 unit, therefore, Total annual differential cost = -$1.5/unit * 50000 unit = -$75,000. This means, the company can save $75,000 a year if they make their own engines.

Recommendation

According to the calculation, it is cheaper if the company chooses to make its own engines ($85.5/unit) rather than buy them from a third party ($87/unit). In one year they can save $75,000 if they make their own engines, therefore it is recommended for the company to make their own engines.

As for which financial information is relevant and not relevant, according to Gordon (2022), sales revenues, production costs, and opportunity costs are relevant since differential analysis requires that we consider all revenue and cost differences (costs that differ from one alternative to another) when deciding between alternative courses of action. We need to consider the opportunity costs also since it is the potential benefits that a company loses by choosing one alternative over another (Fernando, 2022)

On the other hand, sunk costs and allocated fixed costs that are not directly linked to the product are irrelevant because sunk costs incurred in the past cannot be changed by future decisions, and allocated fixed costs that are not linked to the product have no impact on the differential analysis.

Conclusion

According to calculation, it is cheaper for the company to produce its own engines however, there are other factors to consider, including the quality of in-house production and the proficiency of the manufacturing staff and product line. They should also consider converting the free space and time generated by the outsourcing into other revenue streams or improving other aspects of the business.

To conclude, differential analysis is very useful in supporting the company to make business decisions. It immediately highlights the differences between the two options so that the management can make a better future decision.

References

Fernando, J. (2022, June 7). Understanding Opportunity Cost. Investopedia. Retrieved July 10, 2022, from https://www.investopedia.com/terms/o/opportunitycost.asp

Gordon, J. (2022, April 7). Differential analysis (Accounting) — Explained. The Business Professor, LLC. Retrieved July 10, 2022, from https://thebusinessprofessor.com/en_US/accounting-taxation-and-reporting-managerial-amp-financial-accounting-amp-reporting/differential-analysis-accounting-explained

Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html

Note:
This article is written based on University of The People Managerial Accounting (BUS 5110) written assignment by Fristy Tania in June 2022