Make-or-Buy Decision Arches Manufacturing had always made its components in-house. However, Canyonlands Component Works had recently offered to supply one component, DA, at a price of $52 each. Arches uses 10,000 units of component DA each year. The cost per unit of this component is as follows: Direct materials $25.00 6.25 Direct labor Variable overhead 15.75 Fixed overhead 9.00 Total $56.00 Assume that 80% of Arches Manufacturing's fixed overhead for component DA would be eliminated if that component were no longer produced. Required: 1. Conceptual Connection: If Arches decides to purchase the component from Canyonlands, by how much will operating income increase or decrease (as compared to making the component in-house)? Increase Which alternative is better? Purchase the component from Canyonlands 2. Conceptual Connection: Briefly explain how increasing or decreasing the 80% figure affects Arches's final decision to make or purchase the component. As the percentage of avoidable fixed cost increases (above 80% ), total relevant costs of making the component increase, causing the "purchase" decision to be financially appealing (compared to the "make" option) than it was when the percentage was 80%. In other words, as the percentage increases, difference between the "purchase" and "make" options increases resulting in the "purchase decision being even more more percentage of avoidable fixed costs decreases, the "make" option eventually is equally costly and as equally attractive. Alternatively, as the appealing financially as the 1. Conceptual Connection: If Arches decides to purchase the component from Canyonlands, by how much will operating income increase or decrease (as compared to making the component in-house)? Increase Which alternative is better? Purchase the component from Canyonlands 2. Conceptual Connection: Briefly explain how increasing or decreasing the 80% figure affects Arches's final decision to make or purchase the component. more As the percentage of avoidable fixed cost increases (above 80 %), total relevant costs of making the component increase, causing the "purchase" decision to be financially appealing (compared to the "make" option) than it was when the percentage was 80%. In other words, as the percentage increases, attractive. Alternatively, as the difference between the "purchase" and "make" options increases resulting in the "purchase" decision being even more appealing financially as the percentage of avoidable fixed costs decreases, the "make" option eventually is equally "purchase" option. Finally, as the percentage of avoidable fixed cost decreases low enough and the total relevant costs of making the component decrease, the "make" option becomes the more financially appealing option. costly and as equally 3. Conceptual Connection: By what dollar amount would the per-unit relevant fixed cost have to decrease before Arches would be indifferent (ie., incur the same cost) between "making" versus "purchasing" the component? Feedback Check My Work 1. Relevant costs are future costs and differ across alternatives. Determine relevant costs for both alternatives. Set up four columns. First column lists all costs. Second and third columns are for alternatives, make or buy and list all amounts. Fourth column is the differential cost to make. Multiply the amount in fourth column by number of units to determine increase/decrease in operating income. 2. Consider the relevant make and buy costs.