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.

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

Blanche Corporation, a high-end digital camera manufacturer, currently purchases a component part from an outside company at a price of $141 per unit. While the quality of the component has always been very high, Blanche Corporation's management believes it might be possible to produce a superior component internally at a cost lower than $141. The accounting department has provided an estimate of the per-unit manufacturing cost of the component.

Direct materials	77
Direct labor	45
Variable factory overhead	25
Fixed factory overhead	30
	$177

The company's controller believes that the estimate may be incorrect, because Blanche 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 Blanche Corporation should purchase the components from an outside company or manufacture them internally? $

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

Complete the table below to compare the per-unit cost for Blanche 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 Blanche Corporation to SelectbuymakeCorrect 16 of Item 3 the component. Doing so will save the company $ per unit.