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Make or Buy Decisions
When a product or a component can be manufactured in house or purchased/outsourced from a supplier, a make or buy decision will determine which option is optimal.
Things to consider:
- Variable Costs to produce
- Avoidable Fixed Costs if purchased/outsourced
- Purchase price if outsourced
- Opportunity Cost
- Can the idle capacity caused by purchasing from a supplier be used to make more profit
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Example: Make-or-Buy Decisions
The estimated costs of producing 6,000 units of a component are:
The same component can be purchased from market at a price of $31 per unit. If the component is purchased from market, 25% of the fixed factory overhead will be saved.
- Should the component be purchased from the market?
- If the release productive capacity could be used to generate an additional $10,000 of profit, would your answer from part 1 change?
Practice: Make-or-Buy Decisions
Johnson Motors manufactured 500 gears that are used in its motors and incurred the following costs:
A supplier has offered to sell the gears to Johnson for $200 each. The fixed manufacturing overhead consists mainly of depreciation on the equipment used to manufacture the part and would not be reduced if the gears were purchased from the outside firm. If the gears are purchased from the supplier, Johnson can use the factory equipment to produce 500 units of a new product which can be sold for $10 each and would have a variable manufacturing cost per unit of $4 per unit.
What is the total change in income if the units are purchased from the supplier?