Make or Buy Decisions
Manufacturing companies are always concerned with cutting costs to maximize profits. Their managers are faced with challenging situations that requires them to make important decisions in their operations. For example, a company may face stiff competition from its competitors and face the decision of buying some parts of their production process rather than building the parts themselves.This decision commonly known as make or buy decision involves performing a differential analysis. Based on those calculations, managers may be able decide whether to make a given product or buy the product instead of manufacturing the product.
To better understand how to go about this, we are going to have an example of a situation in a production setting that requires an incremental analysis decision.
Example of Make or Buy Problem - Scenario
Due to a stiff competition in the technology sector, Adapticos Inc. is considering buying its adapters for $10 per adapter in order to save all the current variable overhead costs and some $9,000 of the fixed costs. Currently Adapticos Inc. makes 6,000 adapters a month. Could Adapticos buy adapters for $10 per unit or continue making their own adapters based on the data given below?
| Costs | |
|---|---|
| Direct Materials | $5,000 |
| Direct Labor | $10,000 |
| Variable Costs | $15,000 |
| Fixed Costs | $19,000 |
Solution -Differential Analysis Approach
Note that Adapticos Inc. makes 6,000 adapters a month.
| Make Option | Buy Option | Incremental Difference | |
|---|---|---|---|
| Direct materials | $5,000 | 0 | $5,000 |
| Direct Labor | $10,000 | 0 | $10,000 |
| Overhead | |||
| Variable | $15,000 | 0 | $15,000 |
| Fixed | $19,000 | $10,000 | $9,000 |
| Buying $10 a unit | 0 | $60,000 | ($60,000) |
| Total Costs | $49,000 | $70,000 | ($21,000) |
Based on the incremental analysis above, to make the adapters will cost Adapticos Inc. $49,000 a month while the buying the adapters will cost the company $70,000 a month. The company will lose $21,000 from buying the products. By making the adapters, the company will save $21,000 instead of buying the adapters. It is clear that making the adapters is the best option to choose.