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BU8101 Accounting: A User Perspective

Lecture 10
Relevant Costs, Incremental Analysis
Recommended Reading: WHB 16th edition Chapter 21 Other Reference: Financial and Managerial Accounting: Information for Decisions

John J Wild, Barbara Chiapetta

Chapter 23 Lecture Date: 25 March 2013

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(3) Make or Buy Decisions

Should I continue to make the part, or should I buy it? What will I do with my idle facilities if I buy the part?

I suppose I should compare the outside purchase price with the additional costs to manufacture the part.

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Make or Buy Decisions

Outsourcing - Definition

Outsourcing

The decision to buy or subcontract a component product or service rather than produce it in-house. May lead to reduced control over delivery time or product quality. Outsourcing is a regular feature of companies with limited resources.

Why Outsource?
Cost savings. Focus on core business. Knowledge: access to intellectual property, wider experience. Access to talent.

Factors to Consider:

Reliability of supplier delivery, quality, price etc.

Flexibility to adapt to changing conditions.

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Make or Buy Decisions

Incremental costs are also important in the decision to make a product or buy it from a supplier.

The cost to produce an item must include

(1) direct materials (usually avoidable VC) (2) direct labor (avoidable VC)

(3) incremental overhead (unavoidable v. avoidable F.C.)

We should NOT use the predetermined overhead rate to determine product cost.

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Make or Buy Decisions

Excel makes computer chips used in one of its products. Unit costs, based on production of 20,000 chips per year, are:

Unit Costs Direct Materials Direct Labor Variable Overhead Fixed Overhead Total $ 9.00 5.00 1.00 13.00 $ 28.00

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Make or Buy Decisions

An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased.
Irrelevant cost: same under both alternatives

Excel has no alternative use for the facilities. Should Excel accept the offer?

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Make or Buy Decisions

Make Direct Material Direct Labor Variable Overhead Purchase costs Total $ 9.00 5.00 1.00 15.00 $ Buy - 0 25.00

$ 25.00

Incremental costs = $10

Excel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Unavoidable fixed costs are irrelevant.
DECISION RULE Outsource if there is incremental benefits

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Avoidable Fixed Cost Fixed Overhead $13, out of which $3 is avoidable.

Make Direct Material Direct Labor Variable Overhead Purchase costs Avoidable Fixed Overhead Total $ 9.00 5.00 1.00 15.00 $ Buy - 0 25.00 (3.00) 22.00

Incremental costs = $7

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Avoidable Fixed Cost Fixed Overhead $13, out of which $3 is avoidable.

Make Direct Material Direct Labor Variable Overhead Purchase costs Avoidable Fixed Overhead Total $ 9.00 5.00 1.00 3.00 18.00 $ Buy - 0 25.00 25.00

Incremental costs = $7

QUESTION What is the maximum price that the company can pay the external supplier for the outsourced part?

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Avoidable Fixed Cost Fixed Overhead $13, out of which $3 is avoidable.

Make Direct Material Direct Labor Variable Overhead Purchase costs Avoidable Fixed Overhead Total $ 9.00 5.00 1.00 3.00 18.00 $ Buy - 0 25.00 25.00

Incremental costs = $7 Maximum Price = DM + DL + VOH + Avoidable FOH = $9 + $5 + $1 = $18 + $3

DECISION RULE for Maximum Price All Avoidable Costs (VC or FC)