How to Calculate the Financial Advantage of Buying Electronic Circuits from an Outside Supplier?

What is the financial advantage of buying 18,000 electronic circuits from the outside supplier?

Is it more cost-effective to purchase electronic circuits from an outside supplier or produce them internally?

Answer:

The financial advantage of purchasing from the outside vendor is $36,000.

When Kemp Corporation manufactures 18,000 units of its product per year, the company has the option to buy electronic circuits from an outside supplier for $40 per unit. To evaluate this offer, the company needs to compare the cost of producing the circuits internally with the cost of purchasing them from the outside vendor.

The total cost of producing 18,000 units of electronic circuits internally is $900,000, which includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead costs. However, if the company chooses to buy the electronic circuits from the outside supplier, the total cost would be $720,000 for 18,000 units.

By purchasing the circuits from the outside vendor, the company can save $180,000 in avoidable costs (fixed manufacturing overhead) and generate additional revenue of $180,000 using the freed production capacity to launch a new product. Therefore, the financial advantage of purchasing from the outside vendor is calculated as follows:

Total Avoidable Costs + Additional Revenue - Cost of Purchasing from Outside Vendor = Financial Advantage

($576,000 + $180,000) - $720,000 = $36,000

Based on this calculation, it is more financially advantageous for Kemp Corporation to buy electronic circuits from the outside supplier rather than produce them internally.