BUACC3714 - Make or Buy - Example

Taken from https://accountingexplained.com/managerial/relevant-costing/make-or-buy-decision

The following example illustrates the numerical part of a simple make-or-buy decision.

Example

The estimated costs of producing 6,000 units of a component are:

	Per Unit	Total
Direct Material	$10	$60,000
Direct Labor	8	48,000
Applied Variable Factory Overhead	9	54,000
Applied Fixed Factory Overhead	12	72,000
$1.5 per direct labor dollar
	$39	$234,000

The same component can be purchased from market at a price of $29 per unit. If the component is purchased from market, 25% of the fixed factory overhead will be saved.

Should the component be purchased from the market?

Solution

	Per Unit		Total
	Make	Buy	Make	Buy
Purchase Price		$29		$174,000
Direct Material	$10		$60,000
Direct Labor	8		48,000
Variable Overhead	9		54,000
Relevant Fixed Overhead	3		18,000
Total Relevant Costs	$30	$29	$180,000	$174,000
Difference in Favor of Buying		$1		$6,000

Also see this https://www.cleverism.com/make-or-buy-decision-step-by-step-guide/

EXAMPLE

Here is a hypothetical example for coming to a make-or-buy decision. A reputable skateboard company is now manufacturing the heavy duty bearing that is utilized in its most liked line of skateboards. The business’ accounting section reports the following expenses for manufacturing 8000 units of the bearings internally every year.

Direct Materials	$6	x	8000	=	$48,000
Direct Labor	$4	x	8000	=	$32,000
Supervisor Salary	$3	x	8000	=	$24,000
Variable Overhead	$1	x	8000	=	$8,000
Allocated general overhead	$5	x	8000	=	$40,000
Depreciation of special equipment	$2	x	8000	=	$16,000
Total Expense	$21	x	8000	=	$168,000

An external supplier offered to sell 8000 bearings to the skateboard company for only $19 per bearing. Should the business cease manufacturing the bearings internally or instead, purchase them from an external supplier? To arrive at a make-or-buy decision, the focus should, at all times, be on the relevant costs (the ones that differ between the alternatives). The expenses that differ between alternatives comprise the expenses that could be prevented by buying the bearings from an external supplier.

If the expenses that can be avoided by buying bearings from the external supplier amount to less than $19, the business must continue to manufacture its bearings and reject the external supplier’s offer. On the other hand, if the expenses that can be prevented by buying the bearings from the external supplier amount to more than $19, the external supplier’s offer should be accepted.

You can use the setup below to manage your applicable/avoidable expenses.

Total applicable/avoidable expense for Making 8000 units:

Direct Materials	$6	x	8000	=	$48,000
Direct Labor	$4	x	8000	=	$32,000
Supervisor Salary	$3	x	8000	=	$24,000
Variable Overhead	$1	x	8000	=	$8,000
Allocated general overhead				not	relevant
Depreciation of special equipment				not	relevant
Total Expense	$14	x	8000	=	$112,000

Total expense for Buying 8000 Units:

Outside purchase expense

$19

x

8000

=

$152,000

The difference of $40,000 supports continuing to make 8000 units.

Keep in mind that depreciation of special equipment is mentioned as one of the expenses for manufacturing the bearings internally. Owing to the fact that the equipment has already been bought, this depreciation is a sunken expense and is, therefore, not applicable. If the equipment could be utilized to create another product, this may be a relevant expense as well. Still, we suppose that the equipment has no salvage value and no other use.

In addition, the company is setting aside a part of its general operating expenses, for bearings. Any part of the general operating expenses that would be done away with if the bearings were bought instead of made would be pertinent in this analysis. However, the general operating expenses are possibly a common expense to all the company’s goods produced in the factory and which would continue without changes even if the bearings were bought from outside (is not relevant).

The variable cost (direct labor, direct material and variable overhead) can be prevented if the business does not make the bearing. In addition, we suppose that the supervisor’s salary can also be avoided. This is because at $40,000, it costs less to manufacture the bearings internally than to purchase them from an external supplier.

In conclusion, it may be said, the make-or-buy decision is a very important decision with respect to overall production strategy and the possible implications for asset levels, employment levels and key competencies. Business accounting may appear to be an easy set of equations mirroring the money that enters into a business and that which flows out from it. However, in reality, there are countless intricacies associated with the relationship between various kinds of income and costs. Complexity is particularly obvious in make-or-buy. Considering these aspects, the make-or-buy decision should be weighed with utmost care.