E7-5

Pottery Ranch Inc. has been manufacturing its own finials for its curtain rods. The
company is currently operating at 100% of capacity, and variable manufacturing overhead is
charged to production at the rate of 70% of direct labor cost. The direct materials and direct labor
cost per unit to make a pair of finials are $4 and $5, respectively. Normal production is 30,000
curtain rods per year.
A supplier offers to make a pair of finials at a price of $12.95 per unit. If Pottery Ranch
accepts the supplier’s offer, all variable manufacturing costs will be eliminated, but the $45,000
of fixed manufacturing overhead currently being charged to the finials will have to be absorbed
by other products.
Instructions
(a) Prepare the incremental analysis for the decision to make or buy the finials.

Net Income
Make Buy Increase /
(Decrease)
Direct Material
$120,000 0 $120,000
($30,000 x $4)
Direct Labor
150,000 0 150,000
($30,000 x $5)
Variable Overhead
105,000 0 105,000
($30,000 x 70% x $5)
Fixed Overhead 45,000 $45,000 0
Purchase Price 0 388,500 (388,500)
Total annual cost $420,000 $433,500 ($13,500)

(b) Should Pottery Ranch buy the finials?

Pottery should not buy the finials because of the net loss of $13,500.

(c) Would your answer be different in (b) if the productive capacity released by not making
the finials could be used to produce income of $20,000?
Make Buy Net Income
Annual Cost $420,000 $433,500 ($13,500)
Opportunity Cost 20,000 0 20,000
Total Cost $440,000 $433,500 $6,500