determination whether to produce a component part internally or to buy it from an outside supplier. This decision involves both qualitative and quantitative factors. Qualitative considerations include product quality and the necessity for long-run business relationships with subcontractors. Quantitative factors deal with cost. The quantitative effects of the make-or-buy decision are best seen through the RELEVANT COST APPROACH. For example, assume a firm has prepared the following cost estimates for the manufacture of a subassembly component based on an annual production of 8000 units:
Per Unit Total
Direct materials $ 5 $ 40,000
Direct labor 4 32,000
Variable overhead applied 4 32,000
Fixed overhead applied
(150% of direct labor cost)
6 48,000
Total cost $19 $152,000
The supplier has offered the subassembly at a price of $16 each. Two-thirds of fixed factory overhead, which represents executive salaries, rent, depreciation, and taxes, continue regardless of the decision. Should the company buy or make the product? The key to the decision lies in the investigation of those relevant costs that change between the make or buy alternatives. Assuming that the productive capacity will be idle if not used to produce the subassembly, we can make the following analysis:
Per Unit Total of
8000 units
Make Buy Make Buy
Purchase price $16 $128,000
Direct materials $ 5 $ 40,000
Direct labor 4 32,000
Variable overhead 4 32,000
Fixed overhead that can be
avoided by not making
2 ___ 16,000 ________
Total relevant costs $15 $16 $120,000 $128,000
Difference in favor of
making
$ 1 $8,000
The make-or-buy decision must be investigated in the broader perspective of available facilities. The alternatives are: (1) leaving facilities idle; (2) buying the parts and renting out idle facilities; or (3) buying the parts and using unused facilities for other products.
