Make or Buy (Outsource) Theory and Illustrative Problem

A decision concerning whether an item should be produced internally or purchased from

an outside supplier is often called a make or buy decision;
Make-or-buy decisions are those decisions involving a choice between internal and
external production;
Tangible (e.g. Is packaging materials to be manufactured or purchased?) or services
(e.g. Is the engineering department to perform maintenance of aircon or is this to be
subcontracted?);
Compare net relevant manufacturing (or service) costs with cost of buying the item (or
service);
The better option is the one with the lower total relevant costs;
The maximum purchase price for the company is the total relevant cost to make divided
by the number of units. The maximum purchase price, if the company decides to buy
the good or part from outside sources (suppliers) instead of making it inside, should not
exceed the relevant amount that it will incur if it makes the good or part inside.

General format of computation:

Relevant Cost to Make

DM, DL, VOH
Avoidable FC
Opportunity Cost*
Relevant Cost to buy
Purchase Price
Less: Additional Income (Opportunity Cost)*

*Note: Opportunity cost pertains to the additional income coming from freed-up
facilities (such as rental income from unused space) if the product is purchased
rather than produced; If the opportunity cost is already effected in the relevant
cost to make, it should not be shown in the relevant cost to buy or vice-versa

Illustrative Problem:

A. Ali Company manufactures tables. The purchase price of tables is P40 per unit. To
manufacture the tables, the following unit costs are incurred:

Raw materials P15

Direct labor P10
Variable overhead P4

Fixed overhead (based on the production

requirement of 10,000 units) P20

Total production cost per unit (P15+10+4+20) = P49

 Conclusion: To purchase the material is the better option due to the net
advantage of P9. Right?

Solution:

Relevant costs to make:

Relevant manufacturing costs (variable)
(P29* x 10,000 units) P290,000

Relevant cost to buy:

Purchase price (P40 x 10,000 units) 400,000
Net advantage of make/ Net disadvantage of buy P110,000

*Relevant cost to make per unit (P15+P10+P4) P29

Observations/ Conclusions:
The fixed costs of P200,000 (P20 x 10,000 units) is not included since this is to be
incurred whether to MAKE OR BUY;
Better to make the tables due to the advantage/ cost savings amounting to P110,000
(quantitative)

Consider qualitative factors:

- Is the P110,000 material enough to offset the difficulties/problems in making the
instead of purchasing it?
- If the decision is to buy, are there alternative uses of the resources not utilized when
item is manufactured?
- If the decision is to buy, can suppliers meet production requirements and deliver
timely?
- If the decision is to buy, can suppliers deliver products of the same quality compared
to the one manufactured?
- If the decision is to buy, are there other suppliers available which can offer better
products?

B. Same with problem A except that 30% of the fixed factory overhead could be
eliminated if the company will not manufacture the tables. Should the company
make or buy?

Solution:

Relevant costs to make:

Relevant manufacturing costs (variable)
(P29* x 10,000 units) P290,000
Relevant fixed costs (avoidable)
(30% x P20 x 10,000 units) 60,000 P350,000
 Relevant cost to buy:
Purchase price (P40 x 10,000 units) 400,000
Net advantage of make/ Net disadvantage of buy P 50,000

Observations/ Conclusions:
Difference from problem A is the inclusion of the avoidable fixed costs in the analysis
since this is RELEVANT;
Still, it is better to make the tables due to P50,000 advantage.

C. Same with problem A except that:

Materials and labor costs are expected to increase by 20% the next period;
Fixed factory overhead stays the same except that 40% of the fixed factory
overhead could be eliminated if the company buys the tables;
Production requirement for tables next period will increase by 5,000 units;
Alternative use of resources will result to additional income of P150,000 if tables are
to be purchased.

Should the company make or buy?

Relevant costs to make:

DM and DL ((P15+P10) x 120% x 15,000 units) P450,000
VOH (P4 x 15,000 units) 60,000
Avoidable FC (P200,000 x 40%) 80,000
Opportunity cost (lost income, for make) 150,000 P740,000

Relevant cost to buy:

Purchase price (P40 x 15,000 units) 600,000
Net disadvantage of make/ Net advantage of buy P140,000

Observations/ Conclusions:
Units produced will increase from 10,000 to 15,000 units (increase by 5,000 units to be
applied to variable costs);
Only DM and DL will increase by 20%; VOH stays the same;
Fixed factory overhead costs stays the same at P200,000 (P20 x 10,000 units) since it
was mentioned that fixed costs will not change and the fact that generally, total fixed
costs do not change in relation to changes in the number of units produced/ activity
level;
Alternative use of resources is considered and included in the computation of the
relevant costs to make;
In this problem, it is better to buy the tables due to an advantage of P140,000.