Make or buy

Sometimes businesses encounter a situation where they have to decide between making a particular
product themselves or to buy it from an outside supplier. The decision is based on both financial and
non-financial factors.
In general proposed purchased price is compared with the marginal cost of production. If marginal cost of
the production are more than the price offered by the outside supplier then clearly buying goods in
finished form is a better option. When manufacture of goods displaces existing production, the alternative
use of plant etc., currently employed in manufacturing must be taken into consideration.
To make or buy decision may well be influenced by the availability of spare capacity. If the business has
spare capacity and other conditions are favorable then it will be relatively cheap to manufacture the
product. However, if the spare capacity is not available, the firm will have to displace production of
another product in order to make capacity available to manufacture the product.

Explanation with Solved Example:

Sometimes businesses encounter a situation where they have to decide between making a particular product
themselves or to buy it from an outside supplier. The decision is based on both financial and non-financial
factors.
In general proposed purchased price is compared with the marginal cost of production. If marginal cost of the
production are more than the price offered by the outside supplier then clearly buying goods in finished form is a
better option. When manufacture of goods displaces existing production, the alternative use of plant etc., currently
employed in manufacturing must be taken into consideration.
To make or buy decision may well be influenced by the availability of spare capacity. If the business has spare
capacity and other conditions are favorable then it will be relatively cheap to manufacture the product. However, if the
spare capacity is not available, the firm will have to displace production of another product in order to make capacity
available to manufacture the product.

Factors to Make or Buy Decisions:

There are two important factors to make or buy decisions:

(1) Quantitative factors and (2) Qualitative factors

(1) Quantitative Factors to Make or Buy Decisions:

To understand about quantitative factors, read the following example:

Solved Example:
Furniture Inn manufactures computer tables. Recently a supplier has offered the tables of the same quality @ $14
each with an assurance of continued supply. The following is the budget for 4000 units prepared for the quarter
ending 30 September 2016:
Required:
(a) Should Furniture Inn accept the offer from the supplier?

(b) What would be the decision if the supplier offered the tables at $12 each?

Solution:
Calculation of per table marginal cost of production
a) As marginal cost of production is less than the buying price offered by the supplier so Furniture Inn should continue
production of tables. The distribution, administration and fixed production are irrelevant in the decision as
presumptively they will be incurred in either case.

(b) As in this case they buy in price $12 is less than the marginal cost of production so Furniture Inn should buy the
tables from the supplier and discontinue production of tables provided other things are favorable.

(2) Qualitative Factors to Make or Buy Decision:

Though quantitative considerations are important and may be decisive but make or buy decision may not be
appropriate if relevant qualitative factors are ignored. Some of the qualitative factors relating to make or buy
decision are as follows:
(1) Quality and reliability of goods to be bought as a defective component may damage the reputation and reliability
of the firm’s ability.

(2) Reliability of the supplier on timely deliveries of goods as an interruption in the delivery of a component part may
significantly affect a firm’s operations.

(3) Possibility of ceasing production in near or medium distance future.

(4) Can guarantee be obtained from the supplier about no price change in foreseeable future? A long term contract
with a reliable supplier may solve this problem.

(5) Can an alternative use be found for resources made idle by a decision to purchase from outside.

(6) How long it would take to start manufacturing the product/component again if supplier fails to deliver as promised.
Retaining and rehiring of personnel may be important considerations.

(7) What would be the cost of closing down the production line?

(8) Foreign exchange rates and their effects on the decision.

(9) Import policies and their consistency.

Note: Last two points are applicable only to purchase of goods from a foreign country.

Problem - Monk Company manufactures widulators. Watson Company has

approached Monk with a proposal to sell the company a component use in its widulators
at a price of $12,000 for 4,000 units. Monk is currently making these components in its
own factory. The following costs are associated annually with this part of the process
when 4,000 units are produced:
Direct material $4,000
Direct labor 2,000
Manufacturing overhead (fixed & variable) 6,800
Total $12,800
All but $3,000 of the manufacturing overhead costs will continue if Monk discontinues
making the components. Monk will be able to eliminate machine rental of $1,800 per
year if the components are no longer manufactured.

A. How much are the incremental cost or savings if Monk outsources? Use the
incremental approach to justify your answer.

sol
 Of the $6,800, $3,000 is avoidable, and $3,800 will
continue.

Incremental cost to buy 4,000 components ($

12,000)
Incremental manufacturing savings if bought:
Machine rental $ 1,800
Direct materials 4,000
Direct labor 2,000
Overhead – avoidable portion 3,000
Total Incremental savings 10,800
Incremental cost of buying ($1,200)
components

B. What is the amount of avoidable costs if Monk buys rather than makes the
components?
$10,800 – from part A above….the costs that can be avoided if the alternative course of
action—buying—is taken.

C. Which costs/amounts from above are opportunity costs, if any?

$1,800......the rent savings are given up if the alternative action--buying--is undertaken.
Note that the cost of the products--whether bought or made is still a 'cost' for the
company.

D. Should Monk make or buy the components? Briefly justify your answer.
Monk should make the components. There is an additional cost of $1,200 if Monks
buys the components. Increases in costs are bad choices in decision making because
the cost must be passed on to the customer or absorbed as lower profits by the seller.

Problem - Coleman Company owns a machine that produces a component for the
products the company makes and sells. The company uses 1,800 units of this
component in production each year. The costs of making one unit of this component are
Direct material $7
Variable manufacturing overhead 6
Direct labor 4
Fixed manufacturing overhead 5

The fixed overhead costs are unavoidable, and the unit cost is based on the present
annual usage of 1,800 units of the component. An outside supplier has offered to sell
Coleman this component for $18 per unit and can supply all the units it needs.

A. If Coleman buys the component from the outside supplier instead of making it, how
 much will net income change? Should Coleman make or buy the component? Use the
incremental approach to justify your answer.
Sol:
Since net income decreases, Coleman should continue making the component.
Variable cost = $7 + $6 + $4 = $17
Incremental cost savings from not making component (1,800 x $17) $30,600
Incremental cost of buying component (1,800 x $18) (32,400)
Incremental decrease in net income due to buying component $(1,800)

B. Suppose Coleman could rent the machine to another company for $5,000 per year.
How would your response change to part A? Use the incremental approach to justify
your answer.
Sol:
Since net income increases, the company should choose to buy the components.
Incremental cost savings from not making component (1,800 x $17) $30,600
Incremental Annual rent from machine 5,000
Incremental Cost of buying component (1,800 x $18) (32,400)
Incremental Increase in net income due to buying component $3,200

Problem 3 - Brislin Company makes and sells two products, Olives and Popeyes. The income
statement for the prior year, 2001, was as follows:
Olives Popeyes
Sales $16,000 $24,000
Variable cost of goods sold 6,000 10,000
Manufacturing contribution margin $10,000 $14,000
Fixed production 5,000 7,000
Variable selling and administration 2,000 5,000
Fixed selling and administration 1,000 3,000
Net income $2,000 ($1,000)
Brislin's fixed costs are unavoidable and are allocated to products on the basis of sales
revenue. If Popeyes are dropped, sales of Olives are expected to increase by 40 percent next
year.
A. Use the incremental approach to determine if Popeyes should be dropped.

sol
Incremental revenue ($16,000* 40%) of Olives $ 6,400
Incremental revenue of Popeyes (24,000)
Incremental cost savings of Popeyes CGS +10,000
Incremental cost savings of Popeyes S&A cost +5,000
Incremental variable cost of Olives ($6,000*40%) (2,400)
Incremental s&a cost of Olives ($2,000*40%) (800)

Incremental decrease in income if Popeyes discountinued ($5,800)

Illustration No. 1 Suresh Ltd. is producing a part at a cost of Rs. 11 per unit. The composition of
the cost is as follows: Marginal Costing – Make or Buy Decisions
Materials 3.00
Wages 4.00
Overheads–Variable 2.50
Fixed 1.50
Total 11
Presently, the firm has been incurring a total fixed cost of Rs. 15,000 for manufacturing the
current production of 10,000 units. An outsider is offering the same component, in all aspects
identical in features, for Rs. 10 per unit. On enquiry, it is found from the firm that the machine
that is manufacturing the parts would remain idle as the machinery cannot be utilized elsewhere.
(A) Should the offer be accepted? (B) Would your answer would be different, if the outside firm
reduces the price to Rs. 9, after negotiation. What is the impact of the fixed costs in the decision-
making process?

(Solution: The variable cost of the product is as under

Materials 3.00
Wages 4.00
Overheads–Variable 2.50
Total Variable Cost 9.50

(A) Here, the additional costs (variable costs) for making are Rs. 9.50. The outside market price
is Rs. 10. The outside offer is on a higher side by Rs. 0.50 per unit, so the offer is to be rejected.
For every unit bought outside, it results in a loss of Rs. 0.50 per unit.
(B) Now, the outside firm is willing to reduce the price to Rs. 9, while the variable cost is Rs.
9.50. The offer is to be accepted. So far as the fixed costs Rs. 15,000 is concerned, the firm
would incur, whether the firm makes the product itself or buys it outside. In other words, the
existing fixed costs are not to be considered, while taking a decision.