Question

Make or Buy

Smith Corporation currently manufactures a subassembly for its main product. The costs per unit are as follows:

Direct materials                            $ 1

Direct labor                                     10

Variable overhead                             5

Fixed overhead                                 8

Total                                              $24

Funkhouser Company has contacted Smith with an offer to sell it 5,000 of the subassemblies for $20 each. If Funkhouser makes the subassemblies, $5 of the fixed overhead per unit will be allocated to other products.

Required:

a.   Should Smith make or buy the subassemblies? Explain your answer. What would be the impact on Net Income? (Make table)

b.   What if Smith could rent the space currently used to manufacture the subassemblies for $15,000. What should they do now? What is the impact on Net Income? (Make table)

c.   What other factors should Smith consider in making this decision?

Answer 1

Solution a) Differential Analysis of the two options

	Make $	Buy $	Difference in Income $ = Make - Buy
Purchase Price	0.00	20.00	-20.00
Direct Material	1.00	0.00	1.00
Direct Labour	10.00	0.00	10.00
Variable Overheads	5.00	0.00	5.00
Total Variable Cost per Unit	16.00	20.00	-4.00
Total Variable Cost = Total Variable Cost per Unit x 5000 units	80,000.00	1,00,000.00	-20,000.00
Fixed Cost per unit	8.00	3.00	5.00
Total Fixed Cost = Total Fixed Cost per Unit x 5000 units	40,000.00	15,000.00	25,000.00
Total Cost = Total Variable Cost + Total Fixed Cost	1,20,000.00	1,15,000.00	5,000.00
Cost per Unit = Total Cost / 5000 Units	24.00	23.00	1.00

Smith Corporation should buy the subassemblies from Funkhouser Company as that would increase its Net Income by $5,000

Solution b)

	Make $	Buy $	Difference in Income $ = Make - Buy
Purchase Price	0.00	20.00	-20.00
Direct Material	1.00	0.00	1.00
Direct Labour	10.00	0.00	10.00
Variable Overheads	5.00	0.00	5.00
Total Variable Cost per Unit	16.00	20.00	-4.00
Total Variable Cost = Total Variable Cost per Unit x 5000 units	80,000.00	1,00,000.00	-20,000.00
Fixed Cost per unit	8.00	3.00	5.00
Total Fixed Cost = Total Fixed Cost per Unit x 5000 units	40,000.00	15,000.00	25,000.00
Total Cost = Total Variable Cost + Total Fixed Cost	1,20,000.00	1,15,000.00	5,000.00
Cost per Unit = Total Cost / 5000 Units	24.00	23.00	1.00
Income from Renting the Free Space	0.00	15,000.00	15,000.00
Net Cost = Total Cost - Income from Renting the Free Space	1,20,000.00	1,00,000.00	20,000.00

If Smith Corporation receives $15,000 as an income from renting the space then still it will be recommended to buy the subassemblies from Funkhouser Company as that would increase its Net Income by $20,000.

Solution c) Factors Smith Corporation should consider in making this decision:

The Variables considered at the strategic level include analysis of the future, as well as the current environment. Issues like government regulation, competing firms, and market trends all have a strategic impact on the make-or-buy decision.

Elements of the "make" analysis include:

1. Incremental inventory-carrying costs
2. Incremental factory overhead costs
3. Delivered purchased material costs
4. Incremental managerial costs
5. Any follow-on costs stemming from quality and related problems
6. Incremental capital costs

Cost considerations for the "buy" analysis include:

1. Purchase price of the part
2. Transportation costs
3. Receiving and inspection costs
4. Incremental purchasing costs
5. Any follow-on costs related to quality or service