Short Term Decision Making-Make Or Buy (Part 2)

August 20th, 2006 Comments off
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At times, management needs to decide whether to manufacture the product or to buy the ready made from other companies.

The following are some reasons to buy from other companies:

REASONS TO BUY FROM OUTSIDERS

  • Flexibility to meet urgent demand of customers;
  • Overcome limiting factor problem ( Part 1);
  • Concentrate on its own core competencies;
  • Take advantage of the specialist skill and expertise of the outsiders;
  • Overcome production bottleneck and
  • Solve seasonal demand problem

 So, what should Management do in a Make or Buy Decision ?

The suggested approach is to:

COMPARE BETWEEN THE RELEVANT COST OF MAKE OR BUY

If it is cheaper to make, the company should manufacture internally and

If it cheaper to buy then the company should buy from the outsiders

The relevant costs involve the following:

RELEVANT COSTS OF MAKING

=

Variable Cost of Manufacturing like direct materials, direct labors and variable production overheads

+

Any increase in specific Fixed costs

+

Any Opportunity cost involved

RELEVANT COSTS OF MAKING

=

Purchase price

+

Any direct costs relating to purchasing

 

Ilustration:

Company A has to decide whether to manufacture internally or to buy or contract from outsiders.

Company A is able to contract with another company to supply them ready make at $5 each.

The details of Company A internal production costs are as follows:

Direct material/unit $2.00

Direct labor/unit $3.00

Variable production overhead $0.50

Fixed production overhead $0.50

Total production per unit cost $6.00

The company also need to pay for transport charges of $5,000 for the delivery of 3,000 units of the product.

Question : Should Company A make or buy the product?

Solution:

Relevant cost of Making

=Direct material + Direct Labor + Variable Production OH

=($2 + $3 + 0.50) x 3,000 units

=$16,500

Relevant cost of Buying:

= Purchase cost + Transport cost

= ($5 x 3,000) + $5,000

=$20,000

Therefore, it is better for Company A to manufacture internally.

Salient Points to note:

In a Make or Buy situation, there are certain factors to consider:

  • The quality of the products been purchased externally;
  • Whether delivery time is able to be met and
  • Customer loyalty might be affected if sales are forgone due to cases of full capacity

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Financial Accounting

 
 

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