E7-7 Riggs Company purchases sails and produces sailboats.

It currently
produces 1,200 sailboats per year, operating at normal capacity, which is
about 80% of full capacity. Riggs purchases sails at $250 each, but the
company is considering using the excess capacity to manufacture the sails
instead. The manufacturing cost per sail would be $100 for direct materials,
$80 for direct labor, and $90 for overhead. The $90 overhead is based on
$78,000 of annual fixed overhead that is allocated using normal capacity.
The president of Riggs has come to you for advice. It would cost me $270 to
make the sails, she says, but only $250 to buy them. Should I continue
buying them, or have I missed something?
Instructions
1.
Prepare a per unit analysis of the differential costs. Briefly explain
whether Riggs should make or buy the sails.
2.
If Riggs suddenly finds an opportunity to rent out the unused
capacity of its factory for $77,000 per year, would your answer to part
(a) change? Briefly explain.
3.
Identify three qualitative factors that should be considered by
Riggs in this make-or buy decision.
(CGA adapted)
Prepare incremental analysis concerning make-or-buy decision.

SOLUTION
Variable overhead

Particulars
Direct Materials
Direct Labor
Variable overhead
Purchase price
Total annual cost

Total Overhead - ( Annual fixed overhead/no. of sailboats

per year)
$
25.00

MAKE
$
$
$
$
$

100.00
80.00
25.00
205.00

BUY
$
$
$
$
250.00
$
250.00

Net Income
Increase/Decrease
$
100.00
$
80.00
$
25.00
$
(250.00)
$
(45.00)

Decision
The company should consider going on with the manufacturing as for each sailboat they make
a saving of $45

Particulars
Manufacturing cost
Purchase price
Opportunity cost
Total annual cost

MAKE
$
246,000.00
$
-

77000
246,000.00

BUY
$
$ 300,000.00

Net Income
Increase/Decrease
$
246,000.00
$
(300,000.00)

$
$ 300,000.00

$
$

77,000.00
23,000.00

Decision
If the company were to rent out the unused capacity then this would result to a $23,000
increase in net income Hence in this case it would be rational for the company to buy instead
of make.
Other factors to consider
Control over the product quality - If the company produces the product then it has the ability
to ensure that the product quality is maintained unlike when the product is outsourced
Control over the future price of the product -The company should consider what effect
outsourcing will have on future prices of the product as compared to producing it themselves
Potential for interruption of the product - Outsourcing puts the company at risk if their
supplier decides to stop production. Also producing a product internlly may result to
iiinterruptin in the production of other products