Blueprint Problem: Cost-Based Decision Making Make or Buy Decisions

Differential Analysis: Make or Buy

Managers must often decide between two or more alternatives. Differential analysis is used in decision making. When using differential analysis, it is important to only include those amounts that are different between the alternatives. Differential cost is subtracted from differential revenue to determine differential income/loss.

When calculating differential cost, the only costs that should be included are: SelectFixed costsNonavoidable costsRelevant costsSunk costsCorrect 1 of Item 1

For example, manufacturing companies often assemble components into a finished product. These components can be purchased from a supplier or produced within the company. The decision to produce the component or buy it is often referred to as a make-or-buy decision and uses differential analysis to assist in the decision-making process.

Differential analysis is only one step in deciding to make or buy the product. Management must also take into consideration nonquantitative data. If the company has been making the product, will it lay off employees if it starts buying the product? If so, will this hurt the company's reputation? If parts required for making the components will be obtained from an outside source, is that source reliable? These nonquantitative issues will influence the success or failure of a make-or-buy decision.

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Fixed costs do not change in the short run, regardless of any make-or-buy decision.

Non-avoidable costs are, by definition, going to occur regardless of which alternative is chosen.

Relevant costs are costs that will change under different make-or-buy alternatives.

Sunk costs are costs that have occurred in the past.

APPLY THE CONCEPTS: Calculating per-unit manufacturing cost in a make-or-buy decision

Len Corporation, a high-end digital camera manufacturer, currently purchases a component part from an outside company at a price of $205 per unit. While the quality of the component has always been very high, Len Corporation's management believes it might be possible to produce a superior component internally at a cost lower than $205. The accounting department has provided an estimate of the per-unit manufacturing cost of the component.

Direct materials	76
Direct labor	69
Variable factory overhead	33
Fixed factory overhead	70
	$248

The company's controller believes that the estimate may be incorrect, because Len Corporation has excess manufacturing capacity to produce the components without incurring additional fixed factory overhead. What per-unit manufacturing cost should be used in determining whether Len Corporation should purchase the components from an outside company or manufacture them internally? $

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Review the additional feedback from the step above and decide which of these four costs are relevant for a make-or-buy decision.

APPLY THE CONCEPTS: Calculating differential income in a make-or-buy decision

Complete the table below to compare the per-unit cost for Len Corporation to make the component and the per-unit cost to buy the component. If an amount is zero, enter "0".

	Alternatives				Differential Cost to Make
	Make		Buy
Direct materials	$	-	$	=	$
Direct labor		-		=
Factory overhead		-		=
Purchase cost	$	-	$	=	$
Total relevant cost	$	-	$	=	$

Based on your analysis, it is better for Len Corporation to SelectmakebuyCorrect 16 of Item 3 the component. Doing so will save the company $ per unit.