Make or Buy Decisions

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A key consideration here is spare capacity

If Spare production capacity is available

So here we have spare room to MAKE more products, therefore...

  • Production resources may be idle (if the component is purchased from outside)

  • Fixed costs are irrelevant (because we won't need any extra fixed costs)

  • So just consider the variable costs of MAKING compared to the purchase cost of BUYING

Decision

  1. Buy

    If buying price < the variable costs of making

  2. Make

    If buying price > variable costs of making

No spare capacity available?

So we need to buy more space or stop making something to create space

  • Stopping making something to create capacity causes lost contribution

  • So compare the contribution lost + extra costs of MAKING to the purchase price of BUYING

Decision

  1. Buy

    if relevant costs of making > Purchase price

  2. Make

    if relevant costs of making < Purchase price

Illustration

Craft Ltd makes four components A, B, C, and D and the associated annual costs are as follows:

A B C D
Production volume (units) 1,500 3,000 5,000 7,000
Unit variable costs $ $ $ $
Direct Materials 4 4 5 5
Direct Labour 8 8 6 6
Variable production overheads 2 1 4 5
Total 14 13 15 16
Fixed costs directly attributable are: 3,000 6,000 10,000 7,000
The unit prices of an external supplier are: 12 16 20 24
Determine whether any of the components should be bought in from the external supplier.

SOLUTION

  A B C D
Costs if Made 14 13 15 16
Costs if Bought (12) (16) (20) (24)
Savings per unit Bought  2 (3) (5) (8)
Number of units 1,500 3,000 5,000 7,000
         
Total Savings if Bought 3,000 (9,000) (25,000) (56,000)
Plus Direct Fixed Costs Saved 3,000 6,000 10,000 7,000
         
Total Saving 6,000 (3,000) (15,000) (49,000)

Therefore only buy in component A as this is the only one which makes a saving if bought in

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