ACCT1000 Lecture Notes - Lecture 2: Sunk Costs, Opportunity Cost, Net Present Value
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Make-or-Buy Decisions
Organizations are often faced with a make-or-buy decision-adecision of whether to make or to buy components or services usedin making a product or providing a service. For example, a factorycan make a component for a product in-house or purchase it from anoutside supplier.
Example: Each year, Ingmar Company produces13,100 units of a component used in microwave ovens. An outsidesupplier has offered to supply the part for $1.28. The unit costis:
Round intermediate calculations to the nearest cent. Use roundedanswers in subsequent computations, if required.
| Direct materials | $0.75 |
| Direct labor | 0.25 |
| Variable overhead | 0.18 |
| Fixed overhead | 2.42 |
| Total unit cost | $3.60 |
The alternatives for Ingmar Company are: continue making thecomponent in-house, or purchasing the component from the outsidesupplier. Assuming that none of the fixed cost is avoidable,determine which alternative is more cost effective: - Select youranswer -Make the component in-housePurchase from the outsidesupplierItem 1 . If Ingmar accepts the offer to purchase from theoutside supplier, operating income will be $ - Select your answer-higherlowerItem 3 .
Now suppose that Ingmar Company rents machinery capable ofmaking 13,100 units of the component per year and the annual leasecost is $13,100 (this is included in the fixed overhead for thecomponent). The lease can be cancelled whenever Ingmar wantswithout penalty. The machinery lease cost is - Select your answer-relevantnot relevantItem 4 . Determine which alternative is morecost effective: - Select your answer -Make the componentin-housePurchase from the outside supplierItem 5 . If Ingmaraccepts the offer to purchase from the outside supplier, operatingincome will be $ - Select your answer -higherlowerItem 7 .
The make-or-buy decision may be more complex than either examplenoted above. However, the key idea is that relevant costs andbenefits must be distinguished from irrelevant costs and benefits.Therefore, no matter how many costs are involved, the analyst candetermine 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 jobthan the outside supplier. Then, even if it were less expensive topurchase outside, the company could continue to make the componentin-house. Or, perhaps Ingmar Company could use the freed up spaceand workers to make a new, potentially very profitable, product.Then the company might decide to outsource the component even if itappears in the short-run to be a more costly approach.
