Make or Buy Decision

Businesses are sometimes faced with a decision to choose between buying a product that it uses in its operations and making such product.

In relevant costing, the decision to make or buy a product component depends upon the analysis of costs. Generally, managers choose the option that will allow them to save on costs.

The variable cost of manufacturing the product is compared with the purchase price of the product when bought from an outside supplier. Avoidable fixed costs and opportunity costs are also considered in the analysis.

Example

XYZ Company has been manufacturing its own widgets that are used in producing its final product. The cost of manufacturing 10,000 widgets is summarized below.

Direct materials
$20,000
Direct labor
16,000
Variable factory overhead
9,000
Fixed factory overhead
15,000
Total manufacturing costs
$60,000

A supplier offers to produce the widgets that XYZ needs for $5.30 plus freight costs of $0.50 per widget. If the company decides to buy from the supplier, 60% of the fixed factory overhead which represents depreciation and insurance costs will still continue. 40% will be avoided.

a.) Should the company continue to make the widget or purchase it from the outside supplier? Based on comparative analysis of the costs of producing the widgets and costs of buying them, the company should make rather than buy the widget since it will result in $5,000 savings.

Direct materials
$20,000
Direct labor
16,000
Variable factory overhead
10,000
Avoidable fixed factory overhead (40%)
6,000
Cost of manufacturing the widgets
$51,000
Purchase price (10,000 x $5.25)
$52,500
Freight costs (10,000 x $0.50)
5,000
Cost of buying the widgets
$57,000

The above could also be analyzed in another way. The total cost of making the widgets is given at $60,000. If the company purchases them, it will pay $57,000. However, fixed factory costs of $9,000 (60%) will not be avoided. This results in total costs of $66,000. The company will save $6,000 in making the widgets.

b.) Suppose that if the company chooses to buy the widget, the space used to manufacture the widgets before can be rented out to a tenant for $7,500. This is an opportunity cost, added to the cost of manufacturing the widgets.

Direct materials
$20,000
Direct labor
16,000
Variable factory overhead
10,000
Avoidable fixed factory overhead (40%)
6,000
Opportunity cost
7,500
Cost of manufacturing the widgets
$59,500

In this case, the cost of buying the widgets ($57,000) is lower than the cost of manufacturing them ($59,500). Hence, it is better for the company to buy the widgets as it will result in $2,500 savings.

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