Question

Sierra Semiconductors produces? 100,000 high-tech computer chips per month. Each chip uses a component that Sierra makes? in-house. The variable costs to make the component are? $1.30 per? unit, and the fixed costs are? $1,100,000 per month. The company has been approached by a foreign producer who can supply the?component, within acceptable quality? standards, for? $1.20 each. If the company chooses to? outsource, fixed costs can be reduced by? 40%. There are no other uses for the facilities currently employed in making the component. What would be the effect on operating? income, if the company decides to? outsource?

Answer 1

Make or Buy analysis

A Make or Buy analysis always starts by sorting out relevant costs and Irrelevant costs from the total costs.

Relevant cost: Costs that are affected by a decision are known as Relevant costs .

Irrelevant cost: An Irrelevant cost is a cost that will not change as the result of a management decision. As irrelevant costs are not affected by a decision, they are ignored in decision making.

Make or Buy decision:

Step 1 - determining what is relevant cost and what is irrelevant cost for decision making:

Variable costs:

These costs are always relevant costs because these costs are always changes witth the decision. If the company decided to buy the component, then the company won't incur these expenses and on the contrary if the company decided to manufacture internally, then the company will incur these expenses.

Therefore in the given question, the variable cost $1.30 is RELEVANT COST and shall be taken into consideration while MAKE or BUY analysis.

Fixed Cost:

In the given question it is said that 40% of the fixed cost would be reduced if the company opts to buy the component. Since only 40% of the costs are changing with the decison we have to take 40% of the fixed costs into consideraion while MAKE or BUY analysis.

The company will incur 60% of the fixed cost irrespective of the decision company made. 60% of the fixed cost is not changing with the decision and that is why 60% of the fixed cost is IRRELEVANT COST and shall not be considered while MAKE or BUY decision.

Total Fixed cost = $1,100 ,000

Relevant cost = $1,100,000 x 40 % = $440,000

Irrelevant cost = $1,100,000 x 60% = $660,000

Purchase cost:

It is pretty obviou that this cost is a relevant cost. If the company decided to buy the component, then the company will incur these expenses and on the contrary if the company decided to manufacture internally, then the company will not incur these expenses.

Step 2

	Make or Manufacture	Buy
Variable costs	$130,000 [100,000 x $1.30]	--
Fixed cost	$444,000 [$1,100,000 x 40%]	--
Purchases cost	--	$120,000 [100,000 x $1.20]
Total cost	$574,000	$120,000

Step 3 Calculation of effect on Operating income:

Difference between the total costs of the two alternatives = ($574,000 - $120,000) = $454,000.

Therefore, company's operating income will increase by $454,000 if company choose to buy the component externally [company is incurring less cost when it decides to buy the component.]