Question

Structuring a Make-or-Buy Problem

Fresh Foods, a large restaurant chain, needs to determine if it would be cheaper to produce 5,000 units of its main food ingredient for use in its restaurants or to purchase them from an outside supplier for $12 each. Cost information on internal production includes the following:

	Total Cost		Unit Cost
Direct materials	$25,000		$5.00
Direct labor	15,000		3.00
Variable manufacturing overhead	7,500		1.50
Variable marketing overhead	11,000		2.20
Fixed plant overhead	30,000		6.00
Total	$88,500		$17.70

Fixed overhead will continue whether the ingredient is produced internally or externally. No additional costs of purchasing will be incurred beyond the purchase price. If required, round your answers to the nearest whole number.

Required:

1. What are the alternatives for Fresh Foods?

2. List the relevant cost(s) of internal production and of external purchase.

3. Which alternative is more cost effective and by how much? (Use total cost when giving your answer.)

$

4. Now assume that 20% of the fixed overhead can be avoided if the ingredient is purchased externally. Which alternative is more cost effective and by how much? (Use total cost when giving your answer.)

$

Answer 1

Answer :

1. Make the ingredient in house or buy it externally.

2. Relevant cost

	Internal production	external purchase
Direct material	$ 5
Direct labor	$ 3
Variable manufacturing overhead	$ 1.50
Variable marketing overhead	$ 2.20
purchase cost		$ 12
Total Relevant cost	$ 11.70	$ 12

3.

	Buy
cost of purchase ( $ 12*5000)	$ 60000
Fixed plant overhead	$ 30000
Total cost of buying	$ 90000

	make
Direct material $ 5*5000	$ 25000
Direct labor $ 3*5000	$ 15000
Variable manufacturing overhead $ 1.5*5000	$ 7500
Variable marketing overhead $ 2.20*5000	$ 11000
Fixed plant overhead	$ 30000
total cost of making	$ 88500

Make alternative is most cost effective and by $ 1500 ( $ 90000- $ 88500) .

4.

	Buy
cost of purchase ( $ 12*5000)	$ 60000
Fixed plant overhead $ 30000*80%	$ 24000
	$ 84000

	make
Direct material $ 5*5000	$ 25000
Direct labor $ 3*5000	$ 15000
Variable manufacturing overhead $ 1.5*5000	$ 7500
Variable marketing overhead $ 2.20*5000	$ 11000
Fixed plant overhead	$ 30000
	$ 88500

In this scenario Buying  the component is more cost effective by $ 4500 ( $ 88500-$ 84000)