A firm has prepared the following cost estimates for the manufacture of a sub assembly component based on an annual production of 8,000 units.
|Variable factory overhead applied||$4||$32,000|
|Fixed factory overhead applied (150% of direct labor cost)
Executive Salaries, Rent, Depreciation, and Taxes
The supplier has offered to provide 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. Now let us examine if the firm should make the product?
Make-or-Buy Differential Analysis
We need to find out the cost differential when the company makes 8000 product units internally and when they buy the same amount of products. We know if the company decides to buy , the variable costs will go away and only 2/3rd of fixed cost will continue, but each unit of product will cost $16.
Differential costs represent the difference in costs among alternative courses of action. In this case making products in house or buying from supplier. Analyzing this difference is called differential analysis. Differential analysis will help us take decision whether making or buying products financially wise (Heisinger, K., & Hoyle, J. B.,2012).
The firm would purchase 8000 units, so the cost would be 8000 units * $16 per unit = $126000
And if the firm stops making, then the fixed cost (i.e.: $48,000) will go down and would continue with 2/3 rd of it, hence 2/3rd of $48000 = $32,000
|Make Internally||Buy from supplier||Differential Amount||“Make Internally” is|
|Cost to Buy from outside||$0||( 8000 units * $16)=
|Total Direct Material Cost||$40,000||$0||40000||Higher|
|Total Direct Labor cost||$32,000||$0||32000||Higher|
|Total Variable factory overhead applied||$32,000||$0||32000||Higher|
|Fixed factory overhead applied (executive salaries, rent, depreciation, and taxes)||$48,000||$32,000||16000||Higher|
|Total Production costs||$152,000||$158,000||($6,000)||Lower|
If the firm continues making 8000 units, that would cost the firm $152,000
But if the firm decide to buy the 8000 units instead, that would cost them $158,000
The table above with “Differential Analysis” column shows us that if the firm decides to buy that will cost them $6000 more than what they would need to make the 8000 units internally.
Hence the company should make the product.
Retrieved on Heisinger, K., & Hoyle, J. B.(2012). Accounting for Managers.