Parton Company, a manufacturer of snowmobiles, is operating at 80% of plant capacity. Parton's plant manager is considering making the headlights now being purchased from an outside supplier for $12.80 each. The Parton plant has idle equipment that could be used to manufacture the headlights. The design engineer estimates that each headlight requires $4.45 of direct materials, $3.45 of direct labor, and $6.45 of manufacturing overhead. Forty percent of the manufacturing overhead is a fixed cost that would be unaffected by this decision. A decision by Parton Company to manufacture the headlights should result in a net gain (loss) for each headlight of: (CMA adapted)
a) $1.03.
b) $(1.55).
c) $2.32.
d) $3.56.

The Parton Company has a 'make or buy' decision. This decision involves analysing the incremental costs associated with each option. Incremental costs are costs incurred as a result of producing one more unit of a product. If the excess capacity can be utilised to produce the headlights at a lower cost than the cost of acquiring the headlights from an external supplier, then the company should produce the headlights.

The Parton Company incurs $12.80 per headlight purchased from the external supplier. Added to this cost, are the existing costs of operating below plant capacity. If making the headlights in the manufacturing plant yields a positive contribution to fixed costs, then the Parton company should produce the headlights in the manufacturing plant.

By producing the headlights, the Parton company gains a contribution to fixed costs of $1.03 per headlight.

Foregone purchase costs from supplier: $12.80

Incurred costs (directly) from production: ($11.77)

Direct materials ($4.45)

Direct Labour ($3.45)

Manufacturing Overheads: $(6.45*0.6) ($3.87)

Net gain per headlight $1.03