Make or Buy Decision in Segment Report
Make or buy decision: A decision concerning whether an item should be produced internally or purchased from an outside
supplier.
Relevant cost: A cost that differs between alternatives in a decision. This types of cost can be avoided with eliminate any
product or segment. Synonyms are avoidable cost, differential cost, and incremental cost.
Irrelevant cost: A cost that can not differs between alternatives in a decision. This types of cost can not be avoided
with eliminate any product or segment. Synonyms are unavoidable cost, Common fixed cost.
Special order: A one-time order that is not considered part of the company’s normal ongoing business.
Q. “All fixed costs are Irrelevant” Do you agree? Why?
No, we do not agree with the statement. A cost is to be relevant to a particular decision; a cost must meet two criteria:
a. It must be a future cost
b. It must be a differential cost
Not all fixed costs are irrelevant. Some alternatives eliminate some fixed costs when chosen by management; these
eliminated fixed costs are avoidable cost, and others unavoidable fixed cost that cannot avoid with eliminated fixed costs.
Avoidable cost: A cost that can be eliminated by choosing one alternative over another in a
decision. This term is synonymous with relevant cost.
Q. Why Isolate Relevant Costs?
Two different approaches isolate relevant cost:
1.To considered all costs, both those that were relevant and those that were not relevant cost.
2.Considered only the relevant cost.
Q. What is a constrained resource?
Resource constraints occur when project managers do not have enough resources to meet the demands and
outcome of a project. A project may face limited resources in terms of human resources, materials, equipment,
or finances
Make or Buy Decision
For many years Future Company has purchased the starters that are installs in its standard line of farm factors. Due to reduction in
output. The company has idle capacity that could be used to produce the starters. The chief engineer has recommended against this
move, however, pointing out that the cost to produce the starters would be greater than the current TK.8.40 per unit purchase price:
Particulars Total cost Per unit
Direct materials 3.10
Direct labor 2.70
Supervision 60,000 1.50
Depreciation 40,000 1.00
Variable manufacturing overhead 0.60
Rent 12,000 0.30
Total production cost 9.20
A supervisor would have to be hired to oversee production of the starters. However; the company has sufficient idle tools and
machinery that no new equipment would have to be purchased. The rent charge above is based on space utilized in the plant. The
total rent on the plant is TK. 80, 000 per period. Depreciation is due to obsolescence rather than wear and tear.
Required:
Prepare the computations showing how much profit will increase or decrease as a result of making the starters rather than purchases.
Solution:
The target production level is 40,000 starters per period, as shown by the relations between per unit and total
fixed costs.
Particulars Cost per differential costs
Unit Make Buy Explanation
Direct materials 3.10 3.10 - Can be avoided by Buying
Direct labor 2.70 2.70 - Can be avoided by Buying
Variable Manuf. overhead 0.60 0.60 - Can be avoided by Buying
Supervision 1.50 1.50 - Can be avoided by Buying
Depreciation 1.00 - - Sunk costs
Rent 0.30 - - Allocated costs
Outside purchases price - - 8.40
Total 9.20 7.90 8.40
The company should make the staters, rather than continuing to buy from the outside supplier. Making starters will
result in a 0.50 per starters cost saving, or a total saving of 20,000 per period (0.50 per starters*40,000 starters)
=20.000TK.
# Delta company limited produces a single product. The cost of producing & selling a single unit of this product at the company normal activity
level of 60,000 units per year is:
Direct material TK. 5.10
Direct labor TK.3.80
Variable manufacturing overhead TK.1.00
Fixed manufacturing overhead TK.4.20
Variable selling & administration expense TK.1.50
Fixed selling & administration expense TK.1.50
The normal selling price is TK.21 per unit. The company capacity is 75,000 units per unit. An order has been received from a mail order house for
15,000 units at a special price of TK.14 per unit. This order would not affect regular sale.
Required:
1. If this order is accepted by how much will annual profits be increased or decreased. (The order will not change the company fixed cost).
2. Assume the company has 1,000 units of this product left over from last year that are vastly inferior to the current model. The unit must be sold
through regular channels at reduced price. What unit cost figure is relevant for establishing a minimum selling price for this unit? Explain.
Solution:
1. Annual profit will be increased by TK.39,000. Total fixed cost is not relevant to decision, since they will be incurred regardless of
whether the special order is accepted or rejected.
Particulars 15,000 units
Per unit Total taka
Incremental sale 14 2,10,000
Incremental costs
Direct materials 5.10 76,500
Direct labor 3.80 57,000
Variable manufacturing overhead 1.00 15,000
Variable Selling’s & administration 1.50 22,500
Less: Total Incremental costs 11.40 1,71,000
Incremental profit 2.60 39,000
Total fixed cost is not relevant to decision, since they will be incurred regardless of whether the special order is accepted or rejected.
2. The relevant cost is TK. 1.50 (Variable Selling’s & administration). All others variable costs are sunk, since the
units have already been produced. The fixed costs would not be relevant, since they will not change in total as a
consequence of price charged for the left-over units.
