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 $26 each. Zion uses 13,000 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	4.00
Total	$28.75

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?
Increase  $

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

Relevant cost of making in house is equal to the sum of avoidable costs

Total cost of making in house = variable cost + avoidable fixed cost

= 24.75*13,000 + 39,000 = $360,750

Cost of buying from outside = 26*13,000 = $338,000

Increase in Operating Income = $22,750

Increase  $22,750

Buying is better

2.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

2 has been correctly filled and explained

3.relevant per unit fixed cost can be $26-$24.75 = $1.25

Hence, per unit fixed cost has to decrease by $4-$1.25

= $2.75 per unit

i.e. 2.75/4 = 68.75%