Question

1. A company is trying to decide between making or buying a component in one of their products. The fixed and variable costs for both options are given below:

Cost                                                           Make Option                                  Buy Option

Fixed Cost                                                   $25000                                             $3000

Variable Cost                                                 $8                                                     $12

a. Find the break-even quantity and the total cost at the break-even point.

b. If the requirement is 4,500 units, is it more cost-effective for the firm to buy or make the components? What is the cost savings for choosing the cheaper option?

c. If the requirement is 6,000 units, is it more cost-effective for the firm to buy or make the components? What is the cost savings for choosing the cheaper option?

Answer 1

SOLUTION:

a) The volume at which total costs would be same for both costing structures i.e Buy and Make in this case is the Breakeven Point

Let the indifference quantity point in this case be 'x'

Total cost for 'x' units through Making = Total cost for 'x' units through Buying ...... (Fixed Cost + No. of units * Variable Cost)

25000 + 8x = 3000 + 12x

4x = 22000

x = 5500 unit ........... Breakeven Quantity

Total cost at Breakeven Point = 25000 + 8x = 25000 + 8*5500 = $69000 ........ Total Cost

b) @ 4500 units

	Make Option	Buy Option	Cost Saving	Comment
Fixed Cost	25000	3000
Variable Cost	8	12
Total cost @ 4500 units (Fixed Cost + No. of units * Variable Cost)	61000	57000	61000-57000 = 4000	It is cost effective to opt for Buy option, as it will lead to a cost saving of $4000

c) @6000 units

	Make Option	Buy Option	Cost Saving	Comment
Fixed Cost	25000	3000
Variable Cost	8	12
Total cost @ 6000 units (Fixed Cost + No. of units * Variable Cost)	73000	75000	75000-73000 = 2000	It is cost effective to opt for Make option, as it will lead to a cost saving of $2000