Chapter 23: Production Decisions

Analysis of Make or Buy Decisions The analysis of incremental costs and benefits is a crucial part of short-term production decisions, especially when deciding whether a company should manufacture a component internally or buy it from an external supplier. This type of decision, often referred to as a "make or buy" decision, focuses on comparing the costs involved in each option to determine which is more cost-effective. Key Concepts in Make or Buy Decisions: • • Incremental Costs: These are additional costs that arise from making or buying a product. They include direct materials, direct labor, and any additional overhead costs directly related to producing the part in-house. Outsourcing: This involves buying goods or services from an external supplier instead of producing them internally. It can be advantageous if the supplier offers a lower price than the internal production cost. Example: FasTrac's Decision Analysis FasTrac, a manufacturer of exercise supplements and equipment, is considering whether to make a key part internally or continue buying it from an external supplier: • • Current Buy Price: $1.20 per unit. Costs to Make the Part: o Direct Materials: $0.35 per unit. o Direct Labor: $0.50 per unit. o Incremental Overhead Costs: $0.20 per unit (includes costs like power, supplies, and cleanup). Total Cost to Make: 0.35+0.50+0.20=$1.05 per unit0.35 + 0.50 + 0.20 = \$1.05 Since the total cost to make the part ($1.05) is lower than the cost to buy it ($1.20), the analysis suggests that FasTrac should make the part in-house. Decision Rule for Make or Buy: • Select the option with the lower cost. If the incremental costs to make the part are less than the purchase price, it is generally advisable to make the part internally. Conversely, if the purchase price is lower, then buying is the better option. Additional Factors in Make or Buy Decisions: Even when the analysis shows a cost advantage, managers should consider nonfinancial factors, which may outweigh the small differences in unit costs: • • • • Product Quality: Can the company maintain or improve quality by making the part internally? Timeliness of Delivery: Will internal production ensure timely availability, or does the supplier have a better track record? Supplier Relationships: How will this decision impact long-term relationships with suppliers? Employee Morale and Workload: Will making the part in-house increase the workload or affect employee morale? NEED-TO-KNOW Example 23-2: Should the Company Make or Buy? Scenario: A company currently pays $5 per unit to buy a part. The internal costs to make the part are as follows: • • • Direct Materials: $1.50 per unit. Direct Labor: $3.50 per unit. Incremental Overhead Costs: $0.75 per unit. The company also has a predetermined overhead rate of 50% of direct labor cost, but this rate is not relevant in this decision because it is an allocation method rather than an actual additional cost. Calculate the Total Cost to Make the Part: 1.50+3.50+0.75=$5.75 per unit1.50 + 3.50 + 0.75 = \$5.75 Decision: • • • Cost to Make: $5.75 per unit. Cost to Buy: $5.00 per unit. Conclusion: Since the cost to make the part ($5.75) is higher than the cost to buy it ($5.00), the company should buy the part from the external supplier. Summary The make or buy decision hinges on identifying and comparing relevant costs, such as incremental materials, labor, and overhead, with the purchase price. While the financial analysis is essential, managers must also consider qualitative factors that could influence the overall decision. By choosing the lower-cost alternative while keeping non-financial aspects in mind, companies can optimize their operations and maintain flexibility in their production processes.