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 involves proper 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.
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 |
We can also analyze this 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. Hence, if the company makes the widgets, it will save $6,000.
b.) Now, suppose that if the company chooses to buy the widget, the space that would have been used to manufacture the widgets can be rented out to a tenant for $7,500. This is an opportunity cost, added to the cost of manufacturing the widgets since the company will miss this benefit if they manufacture 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 would be better for the company to buy the widgets as it will result in $2,500 savings.
Make or buy decisions are resolved by identifying which decision will result in lower costs and thus, higher profits.
Relevant costs of making a product, including direct materials, direct labor, variable overhead, avoidable fixed costs, and opportunity costs are compared to the purchase cost if it was bought from a supplier.
