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:
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REASONS TO BUY FROM OUTSIDERS |
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So, what should Management do in a Make or Buy Decision ?
The suggested approach is to:
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COMPARE BETWEEN THE RELEVANT COST OF MAKE OR BUY |
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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: |
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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 |
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RELEVANT COSTS OF MAKING = Purchase price + Any direct costs relating to purchasing |
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Ilustration: |
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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. |
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Salient Points to note: |
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In a Make or Buy situation, there are certain factors to consider:
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