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Make-or-Buy Decisions

Organizations are often faced with a make-or-buy decision-a decision of whether to make or to buy components or services used in making a product or providing a service. For example, a factory can make a component for a product in-house or purchase it from an outside supplier.

Example: Each year, Ingmar Company produces 17,500 units of a component used in microwave ovens. An outside supplier has offered to supply the part for $1.30. The unit cost is:

Round intermediate calculations to the nearest cent. Use rounded answers in subsequent computations, if required.

Direct materials	$0.70
Direct labor	0.34
Variable overhead	0.15
Fixed overhead	2.61
Total unit cost	$3.80

The alternatives for Ingmar Company are: continue making the component in-house, or purchasing the component from the outside supplier. Assuming that none of the fixed cost is avoidable, determine which alternative is more cost effective: - Select your answer -Make the component in-housePurchase from the outside supplierItem 1 . If Ingmar accepts the offer to purchase from the outside supplier, operating income will be $ - Select your answer -higherlowerItem 3 .

Now suppose that Ingmar Company rents machinery capable of making 17,500 units of the component per year and the annual lease cost is $17,500 (this is included in the fixed overhead for the component). The lease can be cancelled whenever Ingmar wants without penalty. The machinery lease cost is - Select your answer -relevantnot relevantItem 4 . Determine which alternative is more cost effective: - Select your answer -Make the component in-housePurchase from the outside supplierItem 5 . If Ingmar accepts the offer to purchase from the outside supplier, operating income will be $ - Select your answer -higherlowerItem 7 .

The make-or-buy decision may be more complex than either example noted above. However, the key idea is that relevant costs and benefits must be distinguished from irrelevant costs and benefits. Therefore, no matter how many costs are involved, the analyst can determine the overall quantitative impact of making versus buying. Finally, the qualitative factors must be considered. For example, perhaps Ingmar Company believes that it can do a higher quality job than the outside supplier. Then, even if it were less expensive to purchase outside, the company could continue to make the component in-house. Or, perhaps Ingmar Company could use the freed up space and workers to make a new, potentially very profitable, product. Then the company might decide to outsource the component even if it appears in the short-run to be a more costly approach.

Keep-or-Drop Decisions

A keep-or-drop decision uses relevant cost analysis to determine whether a segment or line of business should be kept or dropped. In a traditional cost management system, segmented income statements, using unit-based fixed or variable costs, improve the ability to make keep-or-drop decisions.

Example: Ginger Company makes three types of microwave ovens. Basic is the small 0.7 cubic foot model sold at discount stores. Countertop is a larger (1.2 cubic foot) model with more advanced features. Built-in is a model designed to fit into cabinetry and is sold through appliance stores. A segmented income statement is shown below.

Sales	$204,260	$865,505	$735,370	$1,805,135
Variable COGS	183,350	302,060	352,300	837,710
Commissions	4,295	43,880	36,865	85,040
Contribution margin	$16,615	$519,565	$346,205	$882,385
Separable fixed expense	30,890	75,555	174,365	280,810
Segment margin	$(14,275)	$444,010	$171,840	$601,575
Common fixed expenses:
Factory overhead				216,360
Selling and administrative expense				290,890
Operating income				$94,325

Ginger Company believes the basic model is a concern and is considering a number of options to deal with this situation. One possibility is to drop the Basic line. If that is done, operating income will be $ - Select your answer -higherlowerItem 2 .

After further study, Ginger Company has found that if the Basic Model is dropped, sales of the Countertop model will decrease by 5 percent as some stores prefer to order only from a company with both basic and countertop models. Now if the Basic line is dropped, operating income will be $ (round to the nearest dollar) - Select your answer -higherlowerItem 4 than if the Basic line is kept.

Cornerstone Exercise 17.3 (Algorithmic) Special-Order Decision, Alternatives, Relevant Costs

Sequoia Paper Products, Inc., manufactures boxed stationery for sale to specialty shops. Currently, the company is operating at 85 percent of capacity. A chain of drugstores has offered to buy 35,000 boxes of Sequoia's blue-bordered thank-you notes as long as the box can be customized with the drugstore chain's logo. While the normal selling price is $6.60 per box, the chain has offered just $3.30 per box. Sequoia can accommodate the special order without affecting current sales. Unit cost information for a box of thank-you notes follows:

Direct materials	$2.15
Direct labor	0.33
Variable overhead	0.07
Fixed overhead	2.15
Total cost per box	$4.70

Fixed overhead is $444,000 per year and will not be affected by the special order. Normally, there is a commission of 9 percent of price; this will not be paid on the special order since the drugstore chain is dealing directly with the company. The special order will require additional fixed costs of $15,700 for the design and setup of the machinery to stamp the drugstore chain's logo on each box.

Required:

1. Which alternative is more cost effective and by how much? - Select your answer -Accept the special orderReject the special orderItem 1

The operating income would increase by $ .

2. What if Sequoia Paper Products was operating at capacity and accepting the special order would require rejecting an equivalent number of boxes sold to existing customers? Which alternative would be better?- Select your answer -Regular salesSpecial orderItem 3

Special Order Decisions

A special-order decision focuses on whether a specially priced order should be accepted or rejected. The "special" price is always lower than normal and is an example of a tactical decision with a short-term focus. Companies must ensure that acceptance of special orders does not jeopardize normal distribution channels or adversely affect other strategic elements. If this qualification is met, special orders often can be attractive, especially when the firm has unused capacity. For this situation, the company can focus its analysis on resources acquired as needed- because this will be the source of any increase in resource spending attributable to the order.

Example: Ellis Company makes boxed stationery and has capacity for 100,000 boxes. Currently, Ellis is producing 80,000 boxes. Information on price and costs is as follows:

Round intermediate calculations to the nearest cent. Use rounded answers in subsequent computations, if required.

Price	$2.40
Direct materials	$0.83
Direct labor	0.70
Variable overhead	0.17
Fixed overhead*	1.18
*Fixed overhead is based on capacity of 100,000 boxes.

A gift store chain recently came to Ellis Company and asked to have 12,900 boxes of stationery printed at a price of $1.85 per box. If Ellis Company accepts the special order, operating income will be $ - Select your answer -higherlowerItem 2 .

Now suppose that the gift store chain requires that a special imprinted seal must be put on each box. Direct materials will increase by $0.07 per box and Ellis can rent the machinery to imprint the seals for $1,439. If Ellis Company accepts the special order with this new requirement, operating income will be $ - Select your answer -higherlowerItem 4 .

Sell or Process Further Decisions

Joint products have common processes and costs of production up to a split-off point. At that point, they become distinguishable. For example, certain minerals such as copper and gold may both be found in a given ore. The ore must be mined, crushed, and treated before the copper and gold are separated. The point of separation is called the split-off point. The costs of mining, crushing, and treatment are common to both products.

Often, joint products are sold at the split-off point. But sometimes, it is more profitable to process a joint product beyond the split-off point prior to selling it. The key point is that all of the joint production costs are irrelevant to the sell or process further decision. By the time the split-off point is reached, all joint costs are sunk, and therefore, irrelevant. The only relevant costs are those incurred beyond the split-off point.

Example: Enviro-Chem Company processes a number of chemical compounds used in producing reagents for the environmental testing industry. One compound is decomposed into two chemicals: guarine and petroline. The cost of processing one batch of compound is $75,400, and the result is 4,340 gallons of guarine and 8,180 gallons of petroline. Enviro-Chem Company can sell the guarine at split-off for $13 per gallon and the petroline for $9 per gallon. Alternatively, the guarine can be processed further at a cost of $6 per gallon (of guarine) into rhydrolite. It takes 4 gallons of guarine for every gallon of rhydrolite. A gallon of rhydrolite sells for $74. If the guarine is sold at split-off, Enviro-Chem will earn sales revenue on guarine of $ . If the guarine is processed further into rhydrolite, Enviro-Chem will earn a net post-split-off amount of $ . It is better for Enviro-Chem Company to - Select your answer -sell the guarine at split-offprocess guarine further into rhydroliteItem 3

Short-Run Decision Making

Currently, Orrin Company makes 40,000 units of a product annually with the following unit manufacturing costs:

Direct materials	$4.00
Direct labor	1.20
Variable overhead	2.40
Fixed overhead	3.50
Total unit cost	$11.10

Orrin Company prices its product at $15 per unit and is selling all it can produce. Recently, Orrin received an offer from Kane Company to buy 5,000 units of the product at $12.50 per unit.

1.

From the list below, check all the relevant costs and benefits Orrin must consider in determining whether or not to accept the order from Kane Company.

(Select "Yes" for the items that are applicable and "No" for the items that do not apply)

$15.00	- Select your answer -YesNoItem 1
$11.10	- Select your answer -YesNoItem 2
$3.90	- Select your answer -YesNoItem 3
$1.40	- Select your answer -YesNoItem 4
$12.50	- Select your answer -YesNoItem 5
$7.60	- Select your answer -YesNoItem 6
$4.90	- Select your answer -YesNoItem 7

2.	If Orrin accepts Kane's order, the impact on operating income for the year will be a(n) (Round your intermediate unit costs to the nearest cent. Use the rounded computations in subsequent requirements, if required.) - Select your answer -decrease by $12,500increase by $12,500increase by $7,000decrease by $7,000be the sameItem 8 .
3.	What is the lowest price Orrin could accept on the special order that would leave it as well off as not accepting the order? - Select your answer -$11.10 per unit$7.60 per unit$12.50 per unit$15.00 per unitItem 9

Use the Interactive Graph to answer the following questions:

Making

Regular price	$15
Special offer price	$10.50 $12.50 $14.50 $16.50

Direct materials	$3 $4 $5 $6	$4.15 $4.50 $5.50 $6.50
Direct labor	$1.2 $1.5 $2 $2.5		new var cost
Variable overhead	$2.4 $6.4 $10.4 $14.4	$7.60	$7.75
Fixed overhead	$3.50 $4.50 $5.50 $6.50
Total unit cost	$11.10

Units capacity per year	30000 35000 40000
Units to sell w/o order
Units in order	5000 10000
Total fixed overhead	$140,000.00
Increased machinery lease	$5,000 $6,000 $7,000 $8,000	$1.2	$8.95

Impact of purchase at capacity

-$12,500.00

increase

Impact of purchase below capacity

-$17,750.00

increase

4.

Now assume that Orrin is currently making and selling 30,000 units (capacity is still 40,000 units). If Orrin accepts Kane's order, the impact on operating income for the year will be a(n) - Select your answer -decrease by $12,500increase by $12,500increase by $24,500decrease by $24,500be the sameItem 10 . What is the lowest price Orrin could accept on the special order that would leave it as well off as not accepting the order? - Select your answer -$11.10 per unit$7.60 per unit$12.50 per unit$15.00 per unit

5.

Assume that Orrin is currently making and selling 30,000 units (capacity is still 40,000 units). Kane offers $12.50 per unit, but requires that Orrin brand each unit with Kane's logo. This will raise direct materials cost to $4.15 per unit and cost Orrin $6,000 to rent special stamping machinery for the year. If Orrin accepts Kane's order, the impact on operating income for the year will be a(n) - Select your answer -decrease by $12,500increase by $12,500increase by $23,750decrease by $23,750decrease by $17,750increase by $17,750be the sameItem 12 . What is the lowest price Orrin could accept on the special order that would leave it as well off as not accepting the order? - Select your answer -$11.10 per unit$7.60 per unit$7.75 per unit$8.95 per unit$12.50 per unit$15.00 per unitItem 13

Continue to vary the purchase price, the cost of manufacturing, and the cost of machine rental to see the impact on operating income if Orrin accepts the order.