Question

Make-or-Buy Decision: Zion Manufacturing had always made its components in-house. However, Bryce Component Works had recently offered to supply one component, K2, at a price of $28 each. Zion uses 12,500 units of Component K2 each year. The cost per unit of this component is as follows:

Direct materials	$12.00
Direct labor	8.25
Variable overhead	4.50
Fixed overhead	6.00
Total	$30.75

Assume that 75% of Zion Manufacturing's fixed overhead for Component K2 would be eliminated if that component were no longer produced.

Required:

1. CONCEPTUAL CONNECTION: If Zion decides to purchase the component from Bryce, by how much will operating income increase or decrease?

Which alternative is better?
Purchase the component from Bryce

2. CONCEPTUAL CONNECTION: Briefly explain how increasing or decreasing the 75% figure affects Zion’s final decision to make or purchase the component.

As the percentage of avoidable fixed cost increases (above 75%), total relevant costs of making the component increase, causing the “purchase” decision to be more  financially appealing (compared to the “make” option) than it was when the percentage was 75%. In other words, as the percentage increases, difference between the “purchase” and “make” options increases resulting in the “purchase” decision being even more  attractive. Alternatively, as the percentage of avoidable fixed costs decreases, the “make” option eventually is equally  costly and as equally appealing financially as the “purchase” option. Finally, as the percentage of avoidable fixed cost decreases low enough and the total relevant costs of making the component decrease, the “make”  option becomes the more financially appealing option

3. CONCEPTUAL CONNECTION: By how much would the per-unit relevant fixed cost have to decrease before Zion would be indifferent (i.e., incur the same cost) between “making” versus “purchasing” the component? If necessary, round your answer to two decimal places.

%

Answer 1

Question 1

If the Company wants to purchase the component from  Bryce, the following costs will:

INCREASE  : Cost of Component $ 28

DECREASE: Direct Material $ 12

Direct Labor $ 8.25

Variable OH $ 4.5

Fixed OH (75%) $ 4.5

NET IMPACT -$ 1.25

So costs will reduce by $1.25 per unit if the company wishes to buy the component from Bryce and so income will increase by $1.25 for every unit. So it is advisable to purchase it from outside market.

Question 2

The analysis provided in the question is absolutely correct. The more the OH are avoidable , the more the relevant costs to make increases and so we can opt to purchase from Bryce. If avoidable costs are reducing , then relevant costs to make decreases and we can go with the option of inherent production.

Question 3

In order to be indifferent , the fixed costs needs to be decreased to the extent of savings from purchasing as calculated above ie., $ 1.25. So if Fixed Costs decreases by $ 1.25 , we can be indifferent in making the component and purchasing it from Bryce.

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