Businesses produce revenue through selling their products to customers.

Businesses can
acquire these products through two methods--either producing them in-house or purchasing
them from manufacturers. Choosing between these two methods is called the make-or-buy
decision, or the outsourcing decision. Factors that influence the make-or-buy decision include
both quantitative factors such as cost and time and qualitative factors such as the suppliers'
trustworthiness and the quality of their products. In these decisions, as with all other
decisions, the only costs that need to be considered are the relevant costs. These relevant
costs are the costs that are different between the two options and usually consist of the
variable costs and avoidable fixed costs. Fixed costs that will simply be transferred to another
department—as allocated costs would be—are not avoidable, because the company as a
whole will still incur those costs in total. These unavoidable costs are therefore irrelevant to
the decision making process.

Sunk costs are also ignored. Because they are historical costs that cannot be changed, they
will be the same for every option the company has.

Management must compare the relevant costs for each option (the costs that would be
incurred only if a particular option is chosen), and then choose the option with the lowest
incremental costs. If the cost to purchase the product from outside is lower than the avoidable
costs of producing the item internally, the company should buy the product from the outside
supplier. Businesses should first conduct an analysis of quantitative factors before factoring
in qualitative factors to complete their make-or-buy decisions.

HOW TO ARRIVE AT A MAKE OR BUY DECISION?

1. Perform the quantitative analysis by comparing the costs incurred in each

option. The cost of purchasing products from suppliers is the price paid to purchase
them. In contrast, the cost of production includes both fixed costs and variable costs.
For example: a business needs 10 units of its product in 10 consecutive periods; it can
either purchase the units at $100 per unit or spend $1,000 to set up production
facilities and $8 to produce each unit. Since the business spends $10,000 (100x10x10)
to purchase the products and $9,000 (1000+10x10x8) to produce the same number of
products, it is better for the business to produce the products based on quantitative
factors alone.
2. Consider qualitative factors that can influence the decision to produce the
products. This includes all relevant factors that cannot be reduced to numbers, such
as the experience of the business' production department and the quality of its
management. For example, it might be possible that the business has no experience in
producing a particular product and its prior experience in producing other products
cannot be applied.
3. Consider qualitative factors that can influence the decision to purchase the
products from outside suppliers. Examples of such factors include the suppliers'
trustworthiness, the quality of its management, and the quality of its products. For

1
 example, it might be possible that the business' supplier has extensive experience in
producing the product being considered and that the business wants to cultivate a
long-term relationship with its supplier.
.
4. Factor the qualitative factors into the quantitative analysis in order to complete
it. For example, in above case, although it is cheaper for the business to produce its
products, there are reasons to believe that its products will be lower quality than those
that it can purchase. Furthermore, since the business wants to cultivate a long-term
relationship with its supplier, it might want to purchase its products from that supplier
in order to initiate the relationship.

5. Come to a final make-or-buy decision once both quantitative and qualitative

factors have been considered; this will depend on the business in question and what
it is doing in order to earn its profits. Continuing to use the above example, although
the business likely can purchase higher-quality products than what it can produce, the
quality of its products might not influence its sales depending on its business model
and what it is selling. If this is the case, the desire to cultivate a long-term relationship
may or may not be enough to outweigh the $1,000 savings in costs; it depends on how
badly the business wants the relationship and what it can hope to achieve by initiating
it.

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 Make-or-buy decisions: non-financial considerations
In reality, however, managers are likely to think about non-financial issues as well as
financial issues when making their decisions. The non-financial considerations in any
decision will depend on the circumstances, and will vary from one decision to
another. Non-financial considerations can influence a decision

Non-financial considerations that will often be relevant to a make-or-buy decision

include the following.
 When work is outsourced, the entity loses some control over the work. It will rely on
the external supplier to produce and supply the outsourced items. There may be some
risk that the external supplier will:
 produce the outsourced items to a lower standard of quality, or
 fail to meet delivery dates on schedule, so that production of the end-product
may be held up by a lack of components.
 The entity will also lose some flexibility. If it needs to increase or reduce supply of
the outsourced item at short notice, it may be unable to do so because of the terms of
the agreement with the external supplier. For example, the terms of the agreement
may provide for the supply of a fixed quantity of the outsourced item each month.
 A decision to outsource work may have implications for employment within the
entity, and it may be necessary to make some employees redundant. This will have
cost implications, and could also adversely affect relations between management and
other employees.

 It might be appropriate to think about the longer-term consequences of a decision to

outsource work. What might happen if the entity changes its mind at some time in the
future and decides either (a) to bring the work back in-house or (b) to give the work to
a different external supplier? The problem might be that taking the work from the
initial external provider and placing it somewhere else might not be easy in practice,
since the external supplier might not be co-operative in helping with the removal of its
work.
The non-financial factors listed above are all reasons against outsourcing work. There
might also be non-financial benefits from outsourcing work to an external supplier.

 If the work that is outsourced is not specialised, or is outside the entity’s main area of
expertise, outsourcing work will enable management to focus their efforts on those
aspects of operations that the entity does best. For example, it could be argued that
activities such as the management of an entity’s fleet of delivery vehicles, or the
monthly payroll work, should be outsourced because the entity itself has no special
expertise on these areas.

 The external supplier, on the other hand, may have specialist expertise which enables
it to provide the outsourced products or services more efficiently and effectively. For
example a company might outsource all its IT support operations, because it cannot
recruit and retain IT specialists. An external service provider, on the other hand, will
employ IT specialists.

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 Summary of Qualitative Factors to be
considered
Factors favouring in-house manufacture
 Wish to integrate plant operations
 Need for direct control over manufacturing and/or quality
 Cost considerations (costs less to make the part)
 Improved quality control
 No competent suppliers and/or unreliable suppliers
 Quantity too little to interest a supplier
 Design secrecy is necessary to protect proprietary technology
 Control of transportation, lead time, and warehousing expenses
 Political, environmental, or social reasons
 Productive utilization of excess plant capacity to assist with absorbing fixed overhead
(utilizing existing idle capacity)
 Wish to keep up a stable workforce (in times when there are declining sales)
 Greater guarantee of continual supply
Factors favouring purchase from outside
 Suppliers’ specialized know-how and research are more than that of the buyer
 Lack of expertise
 Small-volume needs
 Cost aspects (costs less to purchase the item)
 Wish to sustain a multiple source policy
 Item not necessary to the firm’s strategy

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 Limited facilities for a manufacture or inadequate capacity
 Brand preference
 Inventory and procurement considerations
Costs for the make analysis
 Direct labor expenses
 Incremental inventory-carrying expenses
 Incremental capital expenses
 Incremental purchasing expenses
 Incremental factory operating expenses
 Incremental managerial expenses
 Delivered purchased material expenses
 Any follow-on expenses resulting from quality and associated problems
Cost factors for the buy analysis
 Transportation expenses
 Purchase price of the part
 Incremental purchasing expenses
 Receiving and inspection expenses
 Any follow-on expenses associated with service or quality

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Important Terminology:
Variable Cost: Variable costs are those costs that are incurred only if the company actually
produces something. If the company produces no units (sits idle for the entire period) no
variable cost will be incurred by the company. Direct material and direct labour are usually
variable costs. As the total production level increases the total amount of variable cost will
increase but the variable cost per unit will remain same/ unchanged.

Total Variable Cost $10,000 $20,000 $30,000

÷ Units Produced 5,000 10,000 15,000
Variable Cost per Unit $2.00 $2.00 $2.00

Fixed costs: Fixed Costs are costs that do not change in total as the level of production
changes, as long as production remains within the relevant range. The relevant range is the
range of production in which the fixed cost is unchanged. As long as production activity
remains within the relevant range, an increase in the number of units produced will not cause
an increase in the total fixed costs. Fixed costs are best described by looking at a factory as an
example. A factory has the capacity to produce a certain maximum number of units. As long
as production is between 0 and that maximum number of units, the fixed cost for the factory
will remain unchanged. However, once the level of production exceeds the capacity of the
factory, the company will need to build (or otherwise acquire) a second factory. Building the
second factory will increase the fixed costs as the company moves to another relevant range.

Within the relevant range of production the total fixed costs will remain unchanged, but the
fixed costs per unit will decrease as the level of production increases.

Total Fixed Cost $30,000 $30,000 $30,000

÷ Units Produced 5,000 10,000 15,000

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 Fixed Cost per Unit $6.00 $3.00 $2.00

Mixed Costs: Mixed costs or semi-variable costs have properties of both fixed and variable
costs due to presence of both variable and fixed components in them. An example of mixed
cost is telephone expense because it usually consists of a fixed component such as line rent
and fixed subscription charges as well as variable cost charged per minute cost. Another
example of mixed cost is delivery cost which has a fixed component of depreciation cost of
trucks and a variable component of fuel expense.

Since mixed cost figures are not useful in their raw form, therefore they are split into their
fixed and variable components by using cost behavior analysis techniques such as High-Low
Method, Scatter Diagram Method and Regression Analysis.

Relevant Costs and Irrelevant Costs

When making the make-or-buy decision, it is necessary to distinguish between relevant and
irrelevant costs. Relevant cost for making the product are all the costs that could be avoided
by not making the product as well as the opportunity cost incurred by using the production
facilities to make the product as opposed to the next best alternative usage of the production
facilities. Relevant costs for purchasing the product are all the costs associated with buying it
from suppliers. Irrelevant costs are the costs that will be incurred regardless of whether the
product is manufactured internally or purchased externally.

Types of Relevant Costs Types of Non-Relevant Costs

Future Cash Flows Sunk Cost

Cash expense that will be incurred in the Sunk cost is expenditure which has already
future as a result of a decision is a relevant been incurred in the past. Sunk cost is
cost. irrelevant because it does not affect the future
cash flows of a business.
Example:
A company must decide whether to launch a
new product on to the market.
It has spent Rs.900,000 on developing the

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Avoidable Costs
Only those costs are relevant to a decision
that can be avoided if the decision is not
implemented.
Example:
A company has one year remaining on a
short-term lease agreement on a warehouse.
The rental cost is Rs.100,000 per year. The
warehouse facilities are no longer required,
because operations have been moved to
another warehouse that has spare capacity.
If a decision is taken to close down the
warehouse, the company would be
committed to paying the rental cost up to the
end of the term of the lease. However, it
would save local taxes of Rs.16,000 for the
year, and it would no longer need to hire the
services of a security company to look after
the empty building, which currently costs
Rs.40,000 each year.
The decision about whether to close down
the unwanted warehouse should be based on
relevant costs only.
Local taxes and the costs of the security
services (Rs.56,000 in total for the next year)
could be avoided and so these are relevant
costs.
The rental cost of the warehouse cannot be
avoided, and so should be ignored in the
economic assessment of the decision whether
to close the warehouse or keep it open for
another year.
Opportunity Costs
Cash inflow that will be sacrificed as a result
of a particular management decision is a
relevant cost.
Example:
A company has been asked by a customer to
carry out a special job. The work would
require 20 hours of skilled labour time. There
is a limited availability of skilled labour, and
new product, and a further Rs.80,000 on
market research.
A financial evaluation for a decision whether
or not to launch the new product should
ignore the development costs and the market
research costs, because the Rs.980,000 has
already been spent. The costs are sunk costs.
Avoidable Costs
The costs which are immune to a decision in
the sense that they are incurred regardless a
product or activity is continued or dropped.
Example:
A company has one year remaining on a
short-term lease agreement on a warehouse.
The rental cost is Rs.100,000 per year. The
warehouse facilities are no longer required,
because operations have been moved to
another warehouse that has spare capacity.
If a decision is taken to close down the
warehouse, the company would be
committed to paying the rental cost up to the
end of the term of the lease. However, it
would save local taxes of Rs.16,000 for the
year, and it would no longer need to hire the
services of a security company to look after
the empty building, which currently costs
Rs.40,000 each year.
The decision about whether to close down
the unwanted warehouse should be based on
relevant costs only.
Local taxes and the costs of the security
services (Rs.56,000 in total for the next year)
could be avoided and so these are relevant
costs.
The rental cost of the warehouse cannot be
avoided, and so should be ignored in the
economic assessment of the decision whether
to close the warehouse or keep it open for
another year.
Non-Cash Expenses
Non-cash expenses such as depreciation are
not relevant because they do not affect the
cash flows of a business.
Example:
Non-cash items, such as depreciation and
amortization, are frequently categorized as
irrelevant costs for most types of
management decisions, since they do not
8
if the special job is carried out for the impact cash flows.
customer, skilled employees would have to
be moved from doing other work that earns a
contribution of Rs.60 per labour hour.
A relevant cost of doing the job for the
customer is the contribution that would be
lost by switching employees from other
work. This contribution forgone (20 hours ×
Rs.60 = Rs.1,200) would be an opportunity
cost. This cost should be taken into
consideration as a cost that would be incurred
as a direct consequence of a decision to do
the special job for the customer. In other
words, the opportunity cost is a relevant cost
in deciding how to respond to the customer’s
request.
Incremental Cost General Overheads

Where different alternatives are being General and administrative overheads which
considered, relevant cost is the incremental or are not affected by the decisions under
differential cost between the various consideration should be ignored.
alternatives being considered.
Example
A company has identified that each cost unit
it produces has the following costs:
Rs. in ‘000
Direct materials 50
Direct labour 20
70
Fixed production overhead 30
Total absorption cost 100
The incremental cost of making one extra
unit is Rs. 70,000. Making one extra unit
would not affect the fixed cost base.
Differential cost Committed Costs
A differential cost is the amount by which
future costs will be different, depending on Future costs that cannot be avoided are not
which course of action is taken. A differential relevant because they will be incurred
cost is therefore an amount by which future irrespective of the business decision bieng
costs will be higher or lower, if a particular considered.
course of action is chosen. Provided that this Example:
additional cost is a cash flow, a differential A company bought a machine one year ago
cost is a relevant cost. and entered into a maintenance contract for
Example: Rs. 20,000 for three years.
A company needs to hire a photocopier for The machine is being used to make an item
the next six months. It has to decide whether for sale. Sales of this item are disappointing
to continue using a particular type of and are only generating Rs, 15,000 per
photocopier, which it currently rents for annum and will remain at this level for two
Rs.2,000 each month, or whether to switch to years.
using a larger photocopier that will cost The company believes that it could sell the

9
Rs.3,600 each month. If it hires the larger
photocopier, it will be able to terminate the
rental agreement for the current copier
immediately.
The decision is whether to continue with
using the current photocopier, or to switch to
the larger copier. One way of analysing the
comparative costs is to say that the larger
copier will be more expensive to rent, by
Rs.1,600 each month for six months. The
differential cost of hiring the larger copier for
six months would therefore be Rs.9,600
(1600x6).
machine for Rs. 25,000.
The relevant costs in this decision are the
selling price of the machine and the revenue
from sales of the item.
If the company sold the machine it would
receive Rs. 25,000 but lose Rs. 30,000
revenue over the next two years – an overall
loss of Rs. 5,000
The maintenance contract is irrelevant as the
company has to pay Rs. 20,000 per annum
whether it keeps the machine or sells it.
Leases normally represent a committed cost
for the full term of the lease, since it is
extremely difficult to terminate a lease
agreement.

Example for Relevant & Non-relevant Costs:

Butt Industries is a company that manufactures personal care products. It has three divisions:
hair care, skin care and dental care. Following is an extract from the financial statements for
the year ending 31 December 2016:

Hair Care Skin Care Dental Care

Revenue $900 million $600 million $300 million

Net income/(loss) $210 million $100 million ($50 million)

In the board meeting summoned for review of financial statements, a director proposed that
the company should dispose of the dental care division because it is losing money. The CEO
argued that the board can’t conclude that a segment is losing money just because it generated
net loss for a period. He suggested that the company’s chief financial officer should conduct a
detailed analysis for presentation in the next board meeting. Being the company’s
management accountant, the CFO asked you to identify which of the following costs are
relevant for the decision:

1. CEO’s salary
2. Salaries of Dental Care workers who can be laid-off
3. Salaries of Dental Care workers who can’t be laid-off
4. One-time retirement benefits to be paid to laid-off workers
5. Cost of raw materials consumed by Dental Care division
6. Annual directors’ fee
7. Interest paid on loans raised for Dental Care division
8. Salary of the Dental Care chief operating officer
9. Company-wide quality certification fee

10
 10. License fee paid for the rights to manufacture dental care products
11. Head office rent
12. Audit fee (if it doesn’t depends on the number of divisions)

Solution:

We have two alternatives: (a) dental care division is sold off and (b) dental care division
continues to operate. Identifying relevant costs and irrelevant costs is easy when we see if a
cost changes between two alternatives or not. If it changes it is relevant, if it doesn’t it is
irrelevant.

1. CEO’s salary is irrelevant because it shall remain the same whether the dental care
division exists or it is disposed off.

2. Salaries of employees who can be laid off is relevant because the cost shall continue
to be incurred if the division exists but it shall be reduced to zero if the division is
disposed off.
3. Salaries of employees who can’t be laid-off is irrelevant because it shall continue to
be incurred regardless of whether the division is disposed off or not.
4. One-time retirement benefits cost is relevant because it shall be incurred only if the
division is disposed off. If the division continues to operate, the cost shall continue to
be incurred.
5. Cost of raw materials is relevant cost because it shall be zero if the division no longer
operates because then there will be no production.
6. Annual directors fee is irrelevant cost because it shall stay the same even if dental
care is disposed off.
7. Interest paid on dental care division loans is relevant because if the division is sold off
the loan could be paid off which shall cease the interest cost.
8. Salary of the dental care chief operating officer is relevant because he will most likely
lose his job. If he is accommodated in another division, this cost shall be irrelevant.
9. Company-wide quality certification fee is irrelevant because it shall continue to be
incurred even if dental care division is no longer there.
10. License fee paid for manufacturing dental care products is a relevant cost because it
shall cease with disposal of the division.
11. Head office rent is irrelevant because it shall remain the same regardless of the
number of divisions. If a division is sold-off, head-office will still exist and the office
rent shall be incurred.
12. Audit fee is irrelevant if it does not depend on the number of divisions. Audit shall be
conducted even if there is one division less.

Note: A problem may state that some of the variable costs are not avoidable mean non
relevant (explanation given below), meaning that they will still be incurred, even if the
product is purchased. The unavoidable variable costs should not be treated as relevant
costs since they are unavoidable. On the other hand, a problem may state that some of the
fixed costs are avoidable if the company outsources the manufacturing. The avoidable

11
 fixed costs should be treated as relevant costs because they are avoidable.

Non-Relevant Variable Costs: There might be occasions when a variable cost is in fact a
sunk cost (and therefore a non-relevant variable cost). For example, suppose that a company
has some units of raw material in stock. They have been paid for already, and originally cost
Rs. 2,000. They are now obsolete and are no longer used in regular production, and they have
no scrap value. However, they could be used in a special job which the company is trying to
decide whether to undertake. The special job is a Rs.non-off' customer order, and would use
up all these materials in stock.
a. In deciding whether the job should be undertaken, the relevant cost of the materials to the
special job is nil. Their original cost of Rs. 2,000 is a sunk cost, and should be ignored in the
decision.
b. However, if the materials did have scrap value of, say, Rs. 300, then their relevant cost to
the job would be the opportunity cost of being unable to sell them for scrap, i.e. Rs. 300

Note: When determining relevant costs for such types of decisions, the following must be
kept in mind:
• The purchasing costs (purchase price, ordering costs, transportation costs, carrying costs,
etc.) relating to the purchase from an outsider are all relevant variable costs and must be
included in the cost of purchasing the item.
• Only avoidable fixed and variable costs of in-house production are relevant and need to be
included in the cost of producing the item internally.

You must be able to determine the maximum price that the company will be willing to pay an
outside supplier for a product that they currently make. This price is the amount of internal
production costs that will not be incurred (that will be avoided) by purchasing the product
from outside.
Usually, the maximum price that a company would be willing to pay for purchasing
outside the company is:
Maximum Price to Pay = Total Internal Production Costs – Unavoidable Costs (Fixed and Variable)

Q No.01: Medina Co. produces football goal posts for sale to college and professional
football teams. The variable and fixed costs to produce a goal post are as follows:
Direct materials $ 200
Direct labor 150
Indirect variable costs 75
Fixed costs 125
Selling and administrative costs 100
Total $650
Bowden Corp. has recently approached Medina with an offer to supply Medina with finished
goal posts that Medina would then resell under the Medina name. The price of one goal post
from Bowden is $490.
If Medina purchased goal posts from Bowden, all of its fixed costs would continue to be
incurred, but Medina would be able to eliminate half of the selling and administrative costs
that are associated with the production and sale of their own goal posts. The other variable
costs would not be incurred because they would not need to pay any production costs if they
purchase goal posts from an outside supplier.

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Should Medina accept Bowden’s offer, and if not, at what price would Medina be willing to
accept the offer?

Solution:

Medina should not accept the offer from Bowden. If they accept the offer, their total costs
incurred would be $665 per goal post.
Goal post purchase price $490
Fixed costs that would continue 125
Selling and admin. costs that would continue 50
Total cost $665

What is the maximum price Medina would be willing to pay Bowden?

Given that Medina will have $175 per post of internal costs that will continue even if they
purchase from Bowden, the maximum price that they would be willing to pay is $175 less
than their cost of production, or $475 per post.
Other Considerations
Even if Bowden’s offer had been acceptable from a quantitative standpoint, Medina would
need to determine if it is acceptable from a qualitative standpoint. Medina is going to put its
own name on these goal posts and therefore, before accepting any offer to let another
company do the manufacturing, they would need to evaluate other things such as the quality
of Bowden’s manufacturing processes, reliability of delivery, and availability of service if
necessary.

Questions with suggested solutions

Q No.02: The estimated costs of producing 6,000 units of a component are:

Per Unit Total
Direct Material $10 $60,000
Direct Labor 8 48,000
Applied Variable Factory Overhead 9 54,000
Applied Fixed Factory Overhead 12 72,000
$1.5 per direct labor dollar
$39 $234,000
The same component can be purchased from market at a price of $29 per unit. If the
component is purchased from market, 25% of the fixed factory overhead will be saved.
Should the component be purchased from the market?

Solution
Per Unit Total
Make Buy Make Buy
Purchase Price $29 $174,000
Direct Material $10 $60,000
Direct Labor 8 48,000

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Variable Overhead 9 54,000
Relevant Fixed Overhead 3 18,000
Total Relevant Costs $30 $29 $180,000 $174,000
Difference in Favor of Buying $1 $6,000

XYZ Ltd. has an annual production of 90,000 units for a motor component. The component
cost structure is as below:
Particulars Amount (Rs.)
Material 270 per unit
Labour (25% Fixed) 180 per unit
Expenses:
Variable 90 per unit
Fixed 135 per unit
Total 675 per unit

Required:
(a) The purchase manager has an offer from a supplier who is willing to supply the
component at Rs.540. Should the component be purchased and production stopped?
(b) Assume the resources now used for this component’s manufacture are to be used to
produce another new product for which the selling price is Rs. 485.
In the latter case the material price will be Rs. 200 per unit. 90,000 units of this product can
be produced at the same cost basis as above for labour and expenses. Discuss whether it
would be advisable to divert the resources to manufacture that new product, on the footing
that the component presently being produced, be purchased from the market.

Solution:
(a) Statement of Comparative Cost per unit

Manufacture Amount Purchase Amount

(Rs.) (Rs.)
Cost to be incurred due to Purchase cost 540
manufacture
Material 270
Labour 135
Variable overhead 90
Relevant cost 495 540

It’s better to produce a component in house because the relevant cost of manufacturing the
component in house is less than the purchase cost. Further, we can say that unavoidable fixed
cost = (45 + 135) × 90,000 (Deptt. Share) = 1,62,00,000.

14
 (b) Statement of Comparative Cost

Manufacture Amount Purchase Amount

(Rs.) (Rs.)
Cost to be incurred (from Part-a) 495 Purchase cost 540
Benefit to be lost due to manufacturing 60
(WN:1)
Relevant cost 555 540

Hence, It’s better to purchase the component from outside market,

Working Note 1

Calculation of Benefit to be lost

If the component is to be purchased from the market, then the release capacity would provide
the benefit of Rs. 60 per unit as follows:

Particulars Rs.
Selling price - 485
Less: variable cost:
Material - 200
Labour 135
Variable-overheads - 90 425
Benefit lost 60

Q No.03: SS Ltd. is producing a part at a cost of Rs. 11 per unit. The composition of the cost
is as follows:
(Rs.)
Materials 3.00
Wages 4.00
Overheads–Variable 2.50
- Fixed 1.50
11.00
Presently, the firm has been incurring a total fixed cost of Rs. 15,000 for manufacturing the
current production of 10,000 units. An outsider is offering the same component, in all aspects
identical in features, for Rs. 10 per unit. On enquiry, it is found from the firm that the
machine

15
that is manufacturing the parts would remain idle as the machinery cannot be utilized
elsewhere.
(A) Should the offer be accepted?
(B) Would your answer would be different, if the outside firm reduces the price to Rs. 9,
after negotiation. What is the impact of the fixed costs in the decision-making process?

Solution:

The variable cost of the product is as under:

(Rs.)
Materials 3.00
Wages 4.00
Overheads–Variable 2.50
Total Variable Cost 9.50

(A) Here, the additional costs (variable costs) for making are Rs. 9.50. The outside market
price is Rs. 10. The outside offer is on a higher side by Rs. 0.50 per unit, so the offer is to be
rejected. For every unit bought outside, it results in a loss of Rs. 0.50 per unit.

(B) Now, the outside firm is willing to reduce the price to Rs. 9, while the variable cost is
Rs. 9.50. The offer is to be accepted.
So far as the fixed costs Rs. 15,000 is concerned, the firm would incur, whether the firm
makes the product itself or buys it outside. In other words, the existing fixed costs are not to
be considered, while taking a decision.

Q No.04: A firm needs component in an assembly operation. If it wants to do the

manufacturing itself, it would need to buy a machine for Rs. 400,000 which will last for 4
years with no salvage value. Manufacturing costs in each of the 4 years would be Rs.
600,000, Rs. 700,000, Rs. 800,000 , and Rs. 1 million respectively. If the firm had to buy the
components from a supplier, the cost would be Rs. 0.9 million, Rs. 1 million, Rs. 1.1 million
and Rs. 1.4 million respectively in each of the four years. However, the machine would
occupy floor space which would have been used for another machine. This latter machine
would be hired at no cost to manufacture an item, the sale of which would produce net cash
flows in each of the four years of Rs. 0.2 million. It is impossible to find room for both the
machines and there are no other external effects. The cost of capital is 10% and the present
value factor for each of the four years is 0.909, 0.826, 0.751 and 0.683 respectively.

Should the firm make the components or buy from outside?

16
Solution

Evaluation of Make or Buy proposal (All figures are in 00,000 of rupees)

Year P.V. When the component When the component is

factors is manufactured bought from an outside
at 10% supplier
Cash Present value Cash outflow Present
outflow (Buying cost) value
(Rs.) (Rs.) (Rs.) (Rs.)
(a) (b) (c) (d) = (b) × (c) (e) (f) = (b) × (e)
0 1.000 4 4.000 — —
1 0.909 8 7.272 9 8.181
2 0.826 9 7.434 10 8.260
3 0.751 10 7.510 11 8.261
4 0.683 12 8.196 14 9.562
Total 34.412 34.264

* (Capital cost + manufacturing cost + opportunity cost)

= Rs. 34.412 – Rs. 34.264

= Rs. 0.148 (lakhs)

Conclusion: Since there is a saving of Rs. 0.148 (lakhs) in buying the component from
outside, therefore, we should stick to this decision.

17
Q No. 05: X is a multiple product manufacturer. One product line consists of motors
and the company produces three different models. X is currently considering a proposal
from a supplier who wants to sell the company blades for the motors line.

The company currently produces all the blades it requires. In order to meet customer's
needs, X currently produces three different blades for each motor model (nine different
blades).

The supplier would charge Rs. 25 per blade, regardless of blade type. For the next year X
has projected the costs of its own blade production as follows (based on projected
volume of 10,000 units):

Direct materials…………………………………………..……………...Rs. 75,000

Direct labour……………………………………………….……………Rs. 65,000

Variable overhead…………………………………………………….….Rs. 55,000

Fixed overhead

Factory supervision………………………………………………………... Rs. 35,000

Other fixed cost…………………………………...………………….… Rs. 65,000

Total production costs………………………..……………………..….Rs. 2,95,000

Assume (1) the equipment utilized to produce the blades has no alternative use and no
market value, (2) the space occupied by blade production will remain idle if the company
purchases rather than makes the blades, and (3) factory supervision costs reflect the
salary of a production supervisor who would be dismissed from the firm if blade
production ceased.

Required

(i) Determine the net profit or loss of purchasing (rather than manufacturing), the blades
required for motor production in the next year.
(ii) Determine the level of motor production where X would be indifferent between
buying and producing the blades. If the future volume level were predicted to decrease,
would that influence the decision?
(iii) For this part only, assume that the space presently occupied by blade production could
be leased to another firm for Rs. 45,000 per year. How would this affect the make or buy
decision?

18
Solution:

(i) This is a make or buy decision so compare the incremental cost to make with the
incremental cost buy

Incremental Costs
Per Unit (Rs.)
Direct Materials (Rs.75,000 ÷ 10,000 units) 7.50
Direct Labour (Rs.65,000 ÷ 10,000 units) 6.50
Variable Overhead (Rs.55,000 ÷ 10,000 units) 5.50
Supervision (Rs.35,000 ÷ 10,000 units) 3.50
Total Cost 23.00

Compare the cost to make the blades for 10,000 motors. Rs.23.00, with the cost to buy,

Rs. 25.00 There is a net loss of Rs.2.00 if ‘X’ chooses to buy the blades.

(ii) ‘X’ will be indifferent between buying and making the blades when the total costs for
making and buying will be equal at the volume level where:

Variable Cost per unit × No. of units + Avoidable Fixed Cost = Cost of Buy

Variable Cost per unit (DM + DL + VO) × No. of units + Factory Supervision Cost =

Buying Cost per unit × No. of units

Let No. of in units =U

(Rs.7.50 + Rs.6.50 + Rs.5.50) × U + Rs.35,000 = Rs.25.00 U

Rs.19.50 U + Rs.35,000 = Rs.25.00 U

Rs.25.00 U – Rs.19.50 U = Rs.35,000

Rs.5.50 U = Rs.35,000

U = 6,364 units of blades

As volume of production decreases, the average per unit cost of in house production
increases. If the volume falls below 6,364 motors, then ‘X’ would prefer to buy the blades
from the supplier.
(iii) If the space presently occupied by blade production could be leased to another firm
for Rs.45,000 per year, ‘X’ would face an opportunity cost associated with in house blade
production for the 10,000 units of Rs.4.50 (45,000/10000) per unit.
New Cost to Make = Rs.23.00 + Rs.4.50
= Rs.27.50
Now ‘X’ should buy because the cost to make, Rs.27.50, is higher than the cost to buy, Rs.
25.

19
Q No. 06: Golden Bird Ltd. produces and sells Bicycles. It also manufactures the chains for
its Bicycles. It expects to produce and sell 24,000 Bicycles during 2014 –15. It is considering
an offer from an outside vendor to supply any number of chains at Rs. 12 per chains.

The accountant of Golden Bird Ltd. reports the following costs for producing 24,000 chains:

Particulars Cost per Total

unit Cost
(Rs.) (Rs.)
Direct material 5.00 1,20,000
Direct labour 4.00 96,000
Variable manufacturing overhead 2.00 48,000
Inspection, set up etc. 1.00 24,000
Machine rent 1.00 24,000
Allocated fixed overhead 1.25 30,000
Total 14.25 3,42,000
The following additional information is available:
(a) Inspection, set up etc. vary with the number of batches in which the
chains are produced. Currently chains are being produced in the
batch size of 2,000 units.
(b) Direct labour cost represents wages to four workers who are
exclusively engaged in the manufacturing of chains. These workers
are in permanent capacity and cannot be retrenched.
(c) if Golden Bird Ltd. procures all its chains from outside vendor it will
not require the machine which it has hired for manufacturing chains.

Required

(i) Assume that if Golden Bird Ltd. purchase chains from outside vendor, the facility
(including workers) where the chains are currently manufactured will remain idle. Should
Golden Bird Ltd. accept the offer from outside vendor at the anticipated production and sale
volume of 24,000 units.

(ii) Whether your decision in (i) will change if facilities can be used to upgrade the
Bicycle which will result in an incremental revenue of Rs. 22 per Bicycle. The variable cost
for upgrading would be Rs. 18 and tooling cost would be Rs. 16,000.

(iii) Assume that facilities will be used as stated in (ii) above. Further, assume that with
better planning Golden Bird Ltd. will be able to manufacture chains in the batch size of
4,000 units (instead of 2,000 units) if it decides to produce chains inside.

20
Solution

(i) Deciding whether Golden Bird Ltd. should accept the offer from an outside vendor
instead of manufacturing the chains inside.
(Rs.)
Offered Bought Out Price per chain (if Purchased from Outside 12
Vendor)
Less: Variable Cost per unit (if Chains were Produced inside) 7
Excess of Bought Out Price per chain over Variable Cost 5
Total Excess Amount if 24,000 Chains were Purchased 1,20,000
Less: Avoidable Costs
Inspection Setup etc. 24,000
Machine Rent 24,000
Excess of Bought Out Price over Variable and Avoidable Cost 72,000

Golden Bird Ltd. should not accept the offer of an outside vendor because its acceptance
would result in the reduction of profit by Rs. 72,000.

(ii) Deciding whether the use of internal facilities for upgrading the quality of chains the
quality of chains would be beneficial in comparison to their purchase from an outside
vendor.
(Rs.)
Incremental Revenue per Bicycle 22
Less: Differential Cost per Bicycle 18
Contribution per Bicycle 4
Total Contribution (24,000 × Rs.4) 96,000
Less: Tooling Cost 16,000
Net Contribution 80,000

Golden Bird Ltd. should accept the offer of alternative use of facilities for upgrading the
Bicycle as its use, would produce, an incremental net contribution of Rs.80,000, which is
more than the excess of bought out price over variable and avoidable costs by Rs.8,000.

(iii) Deciding whether the use of internal facilities for upgrading the Bicycle (Chain)
internally would be profitable to the concern when the batch size becomes, 4,000 units
in comparison to their purchases from an outside vendor.
When the batch size increases to 4,000 units of chains the concern would be producing 6
batches of output and such an action would reduce the inspection set up cost by
Rs.12,000. In this way there would be a saving of Rs.12,000 towards inspection and set
up costs.
Excess of Bought Out Price is Rs.84,000 (Rs.72,000 + Rs.12,000) [refer to (i)].
If Golden Bird Ltd. utilises internal facilities for producing / upgrading the quality
of bicycle, then it would generate a net contribution of Rs. 80,000 [Refer to (ii)]. On

21
the other hand buying chains from outside would reduce concern’s profitability by
Rs. 84,000.
Hence the use of facilities for upgrading the quality of Bicycle (Chains) is
advocated.

Q No. 07:Jahan Ltd, a ‘Fast-Moving Consumer Goods (FMCG)’ company intends to

diversify the product line to achieve full utilisation of its plant capacity. As a result of
considerable research made, the company has been able to develop a new product called
‘EXE’.
‘EXE’ is packed in cans of 100 ml capacity and is sold to the wholesalers in cartons of
24 cans at Rs.120 per carton. Since the company uses its spare capacity for the
manufacture of ‘EXE’, no additional fixed expenses will be incurred. However
accountant has allocated a share of
Rs. 112,500 per month as fixed expenses to be absorbed by ‘EXE’ as a fair share of the
company’s present fixed costs to the new product for costing purposes.
The company estimates the production and sale of ‘EXE’ at 150,000 cans per month and
on this basis the following cost estimates (per carton) have been developed:
Rs.
Direct Materials …………………………………….54
Direct Wages… ………………..……………. 36
All Overheads ………………………………… …27
Total Costs… ………………………………………….. 117
After a detailed market survey the economy is confident that the production and sales of
‘EXE’ can be increased to 175,000 cans per month and ultimately to 225,000 cans per
month.
The company at present has a capacity for the manufacture of 150,000 empty cans and
the cost of the empty cans if purchased from outside will result in a saving of 20% in
material and 10% in other costs of ‘EXE’. The price at which the outside firm is willing
to supply the empty cans is Rs. 0.675 per empty can. If the company desires to
manufacture empty cans in excess of 150,000 cans, a machine involving an additional
fixed overhead of Rs. 7,500 per month will have to be installed.
Required
(i) State by showing your workings whether the company should make or buy the
empty cans at each of the three volumes of production of ‘EXE’ namely, 150,000,
175,000 and 225,000 cans.
(ii) At what volume of sales will it be economical for the company to install the
additional equipment for the manufacture of empty cans?
(iii) Evaluate the profitability on the sale of ‘EXE’ at each of the aforesaid three
levels of output based on your decision and showing the cost of empty cans as a
separate element of cost.

Solution

(i) If the company increases production to 175,000 cans of ‘EXE’, 150,000 empty cans
should be manufactured and additional 25,000 cans should be purchased at Rs.16,875 [Refer
W.N. 5 & 6]
If the company increases production to 225,000 cans of ‘EXE’, 150,000 empty cans should
be manufactured and additional 75,000 cans should be purchased at a cost of Rs. 50,625.
[Refer W.N. 5 & 6]

22
(ii) Additional fixed overheads to be incurred on a new machine: Rs.7,500 Savings per
unit if empty cans are made instead of buying:
Rs. 0.675 – Rs. 0.6375 = Rs. 0.0375
Minimum additional quantity of empty cans to be made to recover the additional fixed costs:
Rs.7,500/ Rs.0.0375 = 200,000 empty cans
Installation of the new machine for the manufacture of empty cans will be economical at
production level of 3,50,000 cans per month.

(iii) Evaluation of the Profitability on Sale of “EXE” at the 3 Levels.

Per 1,50,000 1,75,000 2,25,000

can can can can
(R (Rs.) (Rs.) (Rs.)
s.)
Sales 5.0000 7,50,000.0 8,75,000.0 11,25,000
0 0 .00
Less: Direct Material 1.8000 2,70,000.0 3,15,000.0 4,05,000.
0 0 00
Direct Wages 1.3500 2,02,500.0 2,36,250.0 3,03,750.
0 0 00
Variable 0.3375 50,625.00 59,062.50 75,937.5
Overheads 0
Empty can made 0.6375 95,625.00 95,625.00 95,625.0
0
Empty can 0.6750 16,875.00 50,625.0
purchases 0
Net Gain 1,31,250.0 1,52,187.5 1,94,062.
0 0 50
Workings

(1) All Overheads for one carton or 24cans Rs.27

Therefore, per can Overheads (Rs.27/24) Rs. 1.125

Fixed Overheads Allocated for 150,000 cans Rs.112,500

Per can Fixed Overheads (Rs.1,12,500 / 1,50,000 cans) Rs.0.75

Variable Overheads per can (Rs.1.125 – Rs.0.75) Rs.0.375

(2) Direct Wage per carton Rs.36

Per can (Rs.36 / 24) Rs.1.50

(3) Direct Materials per carton Rs. 54

Per can (Rs.54 / 24) Rs.2.25

23
 (4) Cost of making one empty can:

Cost Cost % Cost Cost of per

per empty empty can of ‘EXE’
can of can can without
‘EXE’ (Rs.) empty can
(Rs.) (Rs.)
Direct Material 2.250 2 0.4500 1.8000
0
Direct Wages 1.500 1 0.1500 1.3500
0
Variable 0.375 1 0.0375 0.3375
Overheads 0
Total 4.125 0.6375 3.4875

(5) Cost of manufacturing/buying of 150,000 empty cans of ‘EXE’:

Empty can If empty can If empty can

Cost made (Rs.) purchased (Rs.)
(Rs.)
Direct Material 0.4500 67,500.00 -----
Direct Wages 0.1500 22,500.00 -----
Variable 0.0375 5,625.00 -----
Overheads
Purchase Price 0.6750 ----- 101,250.00
Total 95,625.00 101,250.00
Company should manufacture the empty cans for a production volume of
150,000 ‘EXE’ cans as capacity is available and cost of manufacture is lower.

(6) After the level of 150,000 empty cans, the company has to install a new
machine involving a total additional Fixed Overheads of Rs. 7,500. The cost of
making and buying the additional cans of 25,000 and 75,000 will be as follows:

Cost per Make Buy (Rs.) Make Buy (Rs.)

can (Rs.) (Rs.)
(Rs.) 25,000 cans 75,000 cans
Direct Material 0.4500 11,250.00 ----- 33,750.00 -----
Direct Wages 0.1500 3,750.00 ----- 11,250.00 -----
Variable Overheads 0.0375 937.50 ----- 2,812.50 -----
Additional 7,500.00 ----- 7,500.00 -----

24
 Overheads
Purchase Price 0.6750 ---- 16,875.00 ----- 50,625.00
-
Total 23,437.50 16,875.00 55,312.50 50,625.00
The cost of buying additional empty cans at both the levels is lower than the cost
of their manufacture

25
Make-or-buy decisions with scarce resources/Key factor/Limiting Factor
A different situation arises when an entity is operating at full capacity, and has the
opportunity to outsource some production in order to overcome the restrictions on its
output and sales. For example a company might have a restriction, at least in the short-
term, on machine capacity or on the availability of skilled labour. It can seek to
overcome this problem by outsourcing some work to an external supplier who makes
similar products and which has some spare machine time or labour capacity.
In this type of situation, a relevant cost approach is to assume that the entity will:
seek to maximise its profits, and therefore
outsource some of the work, provided that profits will be increased as a consequence.
The decision is about which items to outsource, and which to retain in-house. The
profit-maximising decision is to outsource those items where the costs of outsourcing
will be the least.
To identify the least-cost outsourcing arrangement, it is necessary to compare:
the additional costs of outsourcing production of an item with
the amount of the scarce resource that would be needed to make the item in-house.
Costs are minimised (and so profits are maximised) by outsourcing those items where
the extra cost of outsourcing is the lowest per unit of scarce resource ‘saved’.

A limiting factor is any factor that is in scarce supply and without that further
activities cannot be performed i.e. it limits the organizations activity. Limiting factor or
key factor is ‘Anything which limits the activity of an entity. An entity seeks to optimise
the benefit it obtains from the limiting factor. Examples are a shortage of supply of a
resource or a restriction on sales demand at a particular price’. Key factor may be
anything i.e. materials, labour, machine time, sales quantity etc.

Many times the management has to take a decision whether to produce one product or
another instead. Generally decision is made on the basis of contribution of each product.
Other things being the same the product which yields the highest contribution is best one to
produce. But, if there is shortage or limited supply of certain other resources which may act
as a key factor like for example, the machine hours, then the contribution is linked with
such a key factor for taking a decision. For example, in an undertaking the availability of
machine capacity is limited and the machine hours required for one unit of the two
products are different. In such cases the contribution is to be linked with the machine hour
and the product which yields the highest contribution per machine hour is to be preferred
for taking decision.

Three steps in key factor analysis

Step 1: - First determine the limiting factor (bottleneck resource)
Step 2: - Rank the options using the contribution earned per unit of the scarce resource
Step 3: - Allocate resources

26
 Q No. 08: Agree caps Ltd., engaged in manufacturing agricultural
machinery, is preparing its annual budget for the coming year. The
company has a metal pressing capacity of 20,000 hours, which will be
insufficient for manufacture of all requirements of components A, B, C
and D.
The company has the following choices-
(i) Buy the components entirely from outside suppliers.
(ii) Buy from outside suppliers and / or use a partial
second shift. The data for the current year are given
below-
Standard Production Cost per unit-

A B C D
(Rs. ) (Rs. ) (Rs. ) (Rs. )
Requirement (in units) 2,000 3,500 1,500 2,800
Variable Cost
Direct Materials 37 27 25 44
Direct Wages 10 8 22 40
Direct Expenses 10 20 10 60
Fixed Overhead 5 4 11 20
Total Production Cost 62 59 68 164
Direct expenses relate to the use of the metal presses which cost Rs. 10
per hour, to operate. Fixed overheads are absorbed as a percentage of
direct wages.
Supply of all or any part of the total requirement can be obtained following
prices, each delivered to the factory-
Component (Rs.)
A ....................................................60
B ....................................................59
C… .............................................. 52
D… ............................................. 168
Second shift operations would increase direct wages by 25 percent over
the normal shift and fixed overhead by Rs. 500 for each 1,000 (or part
thereof) second shift hours worked.
Required
(i) Which component, and in what quantities should be manufactured in
the 20,000 hours of press time available?
(ii) Whether it would be profitable to make any of the balance of components
required on a second shift basis instead of buying them from outside suppliers

27
Solution
(i) Components and Quantities to be Manufactured in 20,000 Hours of Press Time
Available (Single Shift Operation)
Hrs.

Available Capacity for Metal Pressing 20,000

First, Produce D, Hours Required (2,800 ×6) 16,800
Balance Hours Available 3,200
Second, Produce A, Hours Required (2,000 × 1) 2,000
Balance Hours Available 1,200
Third, Produce B, for the Balance Hours Available (600 × 2) 1,200
Balance Hours Available Nil
So, in 20,000 hours of press time available, all the requirements of components D
and A and only 600 units of B can be manufactured. The balance requirement of
component B i.e. 2,900 (3,500 – 600) units will have to be bought out or
manufactured in the second shift.

(ii) Since the purchase price of Component C (i.e. Rs. 52) is lower than
the marginal cost of manufacturing (i.e. Rs. 57) in even single shift, it
will not be profitable to make it, hence it should be purchased from
outside.
Now it is to be seen whether 2,900 units of B should be produced in
the second shift or bought from outside. The comparative position is
given below:

Cost of Producing 2,900 units of Component B in Second Shift

(Rs. )
Variable Cost per unit on Single Shift Basis 55.00
Add: Increase in Direct Wages per unit 2.00
Variable Cost per unit 57.00
Total Variable Cost for 2,900 units (2,900 units × Rs.57) 1,65,300
Additional Fixed Cost* 3,000
Total Cost for Producing 2,900 units of B in Second Shift …(A) 1,68,300
Bought Out Price for 2,900 units of B (2,900 units × Rs.59) …(B) 1,71,100
Disadvantage in Buying …(A) – (B) (2,800)
(*) Additional Fixed Cost

5,800 hrs (2,900 units x 2 hrs.) are required for 2,900 units of B. Extra Fixed Cost for
5,800 hrs at Rs. 500 for every 1,000 hours (or part thereof) is Rs.3,000.
28
Since the cost of manufacturing balance quantity of component B i.e. 2,900 units in
second shift is less by Rs.2,800, it is profitable to make it on a second shift basis
instead of buying from outside suppliers.

Working Notes

(a) Process Hours Required

A B C D
(Rs.) (Rs.) (Rs.) (Rs.)
Direct Expenses per unit (A) 10 20 10 60
No. of Press Hours per unit (A/10)
(Direct Expenses per press hour being Rs.10) 1 2 1 6

(b) Marginal Cost of Production per unit Vs Bought Out Price per unit

A B C D
(Rs.) (Rs.) (Rs.) (Rs.)
Marginal Cost
Direct Material 37 27 25 44
Direct Wages 10 8 22 40
Direct Expenses 10 20 10 60
Marginal Cost per unit 57 55 57 144
Bought Out Price 60 59 52 168
Excess of Bought Out Price over Marginal 3 4 (5) 24
Cost
Press Hours per unit 1 2 1 6
Excess of Bought Out Price per unit of 3 2 (5) 4
Limiting Factor (i.e. Press Hour)
Ranking 2 3 1

The bought–out price for component C is lower by Rs.5 than the marginal cost of
production and so it should be purchased from outside.

In case the remaining components A, B, and D are bought, their ranking in terms of
loss per unit of limiting factors (press hour) would be (highest loss per unit), A and B.
The capacity available should, therefore, be deployed for making D first and then A and
thereafter B.

29
Q No. 09: A company manufactures two models of a pocket calculator. The basic model
sells for Rs: 5, has a direct material cost of Rs: 1.25 and requires 0.25 hours of labour time to
produce. The other model, the Scientist, sells for Rs: 7.50, has a direct material cost of Rs:
1.63 and takes 0.375 hours to produce. Labour, which is paid at the rate of Rs: 6 per hour, is
currently very scarce, while demand for the company’s calculators is heavy. The company is
currently producing 8,000 of the basic model and 4,000 of the Scientist model per month,
while fixed costs are Rs: 24,000 per month.
An overseas customer has offered the company a contract, worth Rs: 35,000, for a number of
calculators made to its requirements. The estimating department has ascertained the following
facts in respect of the work:
· The labour time for the contract would be 1,200 hours.
· The material cost would be Rs: 9,000 plus the cost of a particular component not normally
used in the company’s models.
· These components could be purchased from a supplier for Rs: 2,500 or alternatively, they
could be made internally for a material cost of Rs: 1,000 and an additional labour time of 150
hours.
Requirement
Advise the management as to the action they should take.

Solution
In view of its scarcity, labour is taken as the limiting factor. The decision on whether to make
or buy the component has to be made before it can be decided whether or not to accept the
contract. In order to do this the contribution per labour hour for normal production must first
be calculated, as the contract will replace some normal production.

Normal products Basic Scientist

Model - 1 Model – 2
Rs: Rs:
Selling price 5.00 7.50
Materials 1.25 1.63
Labour 1.50 2.25 2.75 3.88
Contribution
÷ ÷ ÷
Limiting Factor(Direct Labour Hr. P.U) 0.25 0.375
Contribution per direct labour hour 9.00 9.65

Therefore, if the company is to make the component it would be better to reduce production
of the basic model, in order to accommodate the special order. The company should now
compare the costs of making or buying the component. An opportunity cost arises due to the
lost contribution on the basic model.

Special contract Manufacture of component

Rs:
Materials 1,000
Labour (Rs: 6 *150 hours) 900
Opportunity cost (150 hours * Rs: 9.00) 1,350
3,250
Since this is higher than the bought-in price of Rs: 2,500 the company would be advised to

30
buy the component from the supplier if they accept the contract. The contract can now be
evaluated:

Contract contribution
Sales revenue Rs. 35,000
Materials Rs. 9,000
Component Rs. 2,500
Labour (Rs: 6 * 1,200) Rs. 7,200 Rs. (18,700)
Contribution Rs. 16,300
÷ ÷
Total Labour Hours 1200
Contribution per direct labour hour Rs. 13.58

Since the contribution is higher than either of the existing products, the company should
accept the contract assuming this would not prejudice the market for existing products. As the
customer is overseas this seems a reasonable assumption.
Because the contribution is higher for the Scientist model it would be wise to reduce
production of the basic model. However, the hours spent on producing the basic model per
month are 8,000 units * 0.25 hours = 2,000, and so the contract would displace more than a
fortnight’s production of the basic model. The recommendation assumes that this can be done
without harming long-term sales of the basic model.

31
Q No. 10:R Co manufactures control panels for fire alarms, a very profitable product. Every
product comes with a one year warranty offering free repairs if any faults arise in this period.
It currently produces and sells 80,000 units per annum, with production of them being
restricted by the short supply of labour. Each control panel includes two main components –
one key pad and one display screen. At present, R Co manufactures both of these components
in-house. However, the company is currently considering outsourcing the production of
keypads and/or display screens. A newly established company based in BB is keen to secure
a place in the market, and has offered to supply the keypads for the equivalent of $4·10 per
unit and the display screens for the equivalent of $4·30 per unit. This price has been
guaranteed for two years.

The current total annual costs of producing the keypads and the display screens are:
Keypads Display screens
Production 80,000 units 80,000 units
$’000 $’000
Direct materials 160 116
Direct labour 40 60
Heat and power costs 64 88
Machine costs 26 30
Depreciation and insurance costs 84 96
Total annual production costs 374 390

Notes.

(1) Materials costs for keypads are expected to increase by 5% in six months’ time; materials
costs for display screens are only expected to increase by 2%, but with immediate effect.

(2) Direct labour costs are purely variable and not expected to change over the next year.

(3) Heat and power costs include an apportionment of the general factory overhead for heat
and power as well as the costs of heat and power directly used for the production of keypads
and display screens. The general apportionment included is calculated using 50% of the direct
labour cost for each component and would be incurred irrespective of whether the
components are manufactured in-house or not.

(4) Machine costs are semi-variable; the variable element relates to set up costs, which are
based upon the number of batches made. The keypads’ machine has fixed costs of $4,000 per
annum and the display screens’ machine has fixed costs of $6,000 per annum. Whilst both
components are currently made in batches of 500, this would need to change, with immediate
effect, to batches of 400.

(5) 60% of depreciation and insurance costs relate to an apportionment of the general factory
depreciation and insurance costs; the remaining 40% is specific to the manufacture of
keypads and display screens.
Required
(a) Advise R Co whether it should continue to manufacture the keypads and display screens
in-house or whether it should outsource their manufacture to the supplier in BB, assuming it
continues to adopt a policy to limit manufacture and sales to 80,000 control panels in the
coming year.
(b) R Co takes 0.5 labour hours to produce a keypad and 0.75 labour hours to produce a

32
display screen. Labour hours are restricted to 100,000 hours and labour is paid at $1 per
hour. R Co wishes to increase its supply to 100,000 control panels (ie 100,000 each of keypads
and display screens).
Advise R Co as to how many units of keypads and display panels they should either
manufacture and/or outsource in order to minimise their costs.

Solution:
(a) Incremental costs of making in-house compared to cost of buying
Keypads (K) Display screens (D)
$ $
Variable costs
Materials:
K = ($160k × 6/12) + ($160k × 1.05 × 6/12) : D = ($116k × 1.02) 164,000 118,320
Direct labour 40,000 60,000
Machine set-up costs:
K = ($26k – $4k) × 500/400 : D = ($30k – $6k) × 500/400 27,500 30,000
(A) 231,500 208,320
Attributable fixed costs
Heat and power: K = ($64k – $20k) : D = ($88k – $30k) 44,000 58,000
Fixed machine costs 4,000 6,000
Depreciation and insurance: K = ($84k × 40%) : D = ($96k × 40%) 33,600 38,400
(B) 81,600 102,400
Total incremental costs of making in-house (A + B) 313,100 310,720
Cost of buying: K = (80,000 × $4.10) : D = (80,000 × $4.30) ( 328,000) (344,000)
Total saving from making 1 4,900 33,280

Alternative approach (Relevant costs)

Keypads (K) Display screens (D)
$ $
Direct materials:
K = ($160k / 2) + ($160k / 2 × 1.05) : D = $116k × 1.02 164,000 118,320
Direct labour 40,000 60,000
Heat and power
K = $64K – (50% × $40K) : D = $88k – (50% × $60k) 44,000 58,000
Machine set-up costs:
Avoidable fixed costs 4,000 6,000
Activity related costs (W1) 27,500 30,000
Avoidable depreciation and insurance costs:
K = ($84k × 40%) : D = ($96k × 40%) 33,600 38,400
Total relevant manufacturing costs 313,100 310,720
Relevant cost per unit (313100/80000;310720/80000) 3.91375 3.884
Cost per unit of buying in (given) (4.10) ( 4.30)
Incremental cost of buying in 0.18625 0.416
As each of the components is cheaper to make in-house than to buy in, the company should
continue to manufacture both products in-house.
Working
Current no. of batches produced = 80,000 / 500 = 160
New no. of batches produced = 80,000 / 400 = 200
Current cost per batch for keypads = ($26,000 – $4,000) / 160 = $137.50
Therefore new activity related batch cost = 200 × $137.50 = $27,500
Current cost per batch for display screens = ($30,000 – $6,000) / 160 = $150
Therefore new activity related batch cost = 200 × $150 = $30,000

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(b) Note. Attributable fixed costs are not included in the following calculation. Attributable
fixed costs remain unaltered irrespective of the level of production of keypads and display
screens, because as soon as one unit of either is made, the costs rise. We know that we will
make at least one unit of each component as both are cheaper to make than buy. They are
therefore an irrelevant common cost.
Plan to minimise costs minimise costs
Keypads (K) Display screens (D)
$ $
Buy-in price 4.10 4.30
Variable cost of making:
K = ($231,500 / 80,000): D = ($208,320 / 80,000) 2.89 2.60
Saving from making (per unit) 1.21 1.70
Labour hours per unit 0.50 0.75
Saving from making (per unit of limiting factor) 2.42 2.27
Priority for making 1 2
Total labour hours available = 100,000 hours
Make maximum keypads, ie 100,000 using 50,000 labour hours (100,000 × 0.5 hours per unit)
Use remaining 50,000 labour hours to make 66,666 display screens (50,000 / 0.75 hours per unit)
Therefore buy in 33,334 display screens (100,000 – 66,666).

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Q No. 11:The management of Spinner plc is considering next year’s production and purchase
budgets. One of the components produced by the company, which is incorporated into another
product before being sold, has a budgeted manufacturing cost as follows:
(£)
Direct material 14
Direct labour (4 hours at £3 per hour) 12
Variable overhead (4 hours at £2 per hour) 8
Fixed overhead (4 hours at £5 per hour) 20
Total cost 54 per unit
Trigger plc has offered to supply the above component at a guaranteed price of £50 per unit.
Required:
(a) Considering cost criteria only, advise management whether the above component should
be purchased from Trigger plc. Any calculations should be shown and assumptions made, or
aspects which may require further investigation should be clearly stated.
(b) Explain how your above advice would be affected by each of the two separate situations
shown below.
(i) As a result of recent government legislation if Spinner plc continues to manufacture this
component the company will incur additional inspection and testing expenses of £56 000
per annum, which are not included in the above budgeted manufacturing costs.
(ii) Additional labour cannot be recruited and if the above component is not manufactured
by Spinner plc the direct labour released will be employed in increasing the production of an
existing product which is sold for £90 and which has a budgeted manufacturing cost as
follows:
(£)
Direct material 10
Direct labour (8 hours at £3 per hour) 24
Variable overhead (8 hours at £2 per hour) 16
Fixed overhead (8 hours at £5 per hour) 40
90 per unit
All calculations should be shown.
(c) The production director of Spinner plc recently said:
‘We must continue to manufacture the component as only one year ago we purchased some
special grinding equipment to be used exclusively by this component. The equipment cost
£100 000, it cannot be resold or used elsewhere and if we cease production of this
component we will have to write off the written down book value which is £80 000.’

Solution:

(a) (£)
Purchase price of component from supplier 50
Additional cost of manufacturing (variable cost only) 34
Saving if component manufactured 16
The component should be manufactured provided the following assumptions are correct:
(i) Direct labour represents the additional labour cost of producing the component.
(ii) The company will not incur any additional fixed overheads if the component is manufactured.
(iii) There are no scarce resources. Therefore the manufacture of the component will not restrict the
production of other more profitable products.

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(b) (i) Additional fixed costs of £56 000 will be incurred, but there will be a saving in purchasing costs
of £16 per unit produced. The break-even point is 3500 units (fixed costs of £56 000/£16 per unit
saving). If the quantity of components manufactured per year is less than 3500 units then it will be
cheaper to purchase from the outside supplier.
(ii) The contribution per unit sold from the existing product is £40 and each unit produced uses 8
scarce labour hours. The contribution per labour hour is £5. Therefore if the component is
manufactured, 4 scarce labour hours will be used, resulting in a lost contribution of £20. Hence the
relevant cost of manufacturing the components is £54, consisting of £34 incremental cost plus a lost
contribution of £20. The component should be purchased from the supplier.
(c) The book value of the equipment is a sunk cost and is not relevant to the decision whether the
company should purchase or continue to manufacture the components. If we cease production now,
the written-down value will be written off in a lump sum, whereas if we continue production, the
written down value will be written off over a period of years. Future cash outflows on the equipment
will not be affected by the decision to purchase or continue to manufacture the components.

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International outsourcing.

Q No. 12:Bernie’s Bears, Inc., manufactures plush toys in a facility in Cleveland, Ohio.
Recently, the company designed a group of collectible resin figurines to go with the plush toy
line. Management is trying to decide whether to manufacture the figurines themselves in
existing space in the Cleveland facility or to accept an offer from a manufacturing company
in Indonesia. Data concerning the decision follows:

Expected annual sales of figurines (in units) 400,000

Average selling price of a figurine $5
Price quoted by Indonesian company, in Indonesian Rupiah (IDR), for each figurine 27,300 IDR
Current exchange rate 9,100 IDR = $1
Variable manufacturing costs $2.85 per unit
Incremental annual fixed manufacturing costs associated with the new product line $200,000
Variable selling and distribution costs* $0.50 per unit
Annual fixed selling and distribution costs* $285,000
* Selling and distribution costs are the same regardless of whether the figurines are
manufactured in Cleveland or imported.

Required
1. Should Bernie’s Bears manufacture the 400,000 figurines in the Cleveland facility or
purchase them from the Indonesian supplier? Explain.
2. Bernie’s Bears believes that the US dollar may weaken in the coming months against the
Indonesian Rupiah and does not want to face any currency risk. Assume that Bernie’s Bears
can enter into a forward contract today to purchase 27,300 IDRs for $3.40. Should Bernie’s
Bears manufacture the 400,000 figurines in the Cleveland facility or purchase them from the
Indonesian supplier? Explain.
3. What are some of the qualitative factors that Bernie’s Bears should consider when deciding
whether to outsource the figurine manufacturing to Indonesia?

Solution:
1. Cost to purchase each figurine from Indonesian supplier = 27,300 IDR / 9,100 IDR/$
=$3
Cost of purchasing 400,000 figurines from Indonesian supplier = $3 x 400,000 figurines =
$1,200,000.

= $2.85 400,000 units + $200,000

= $1,340,000
Variable and fixed selling and distribution costs are irrelevant because they do not differ between
the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the
figurines in Cleveland.
Bernie’s Bears should purchase the figurines from the Indonesian supplier because the cost of
$1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in Cleveland.

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2. If Bernie’s Bears enters into a forward contract to purchase 27,300 IDRs for $3.40, each
figurine acquired from the Indonesian supplier will cost $3.40.
Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40 x 400,000 figurines
= $1,360,000.
Cost of manufacturing 400,000 figurines in Cleveland (see requirement 1) = $1,340,000.
As in requirement 1, selling and distribution costs are irrelevant.
Bernie’s Bears should manufacture the figurines in Cleveland because the relevant cost of
$1,340,000 to manufacture the figurines in Cleveland is less than the cost of $1,360,000 to enter
into the forward contract and purchase the figurines from the Indonesian supplier.

3. In deciding whether to purchase figurines from the Indonesian supplier, Bernie’s Bears should
consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of the
Indonesian Rupiah relative to the U.S. dollar, and (d) the negative public and media reaction to
not providing jobs in Cleveland and instead supporting job creation in Indonesia.

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Q No. 13:Oxford Engineering manufactures small engines. The engines are sold to
manufacturers who install them in such products as lawn mowers. The company currently
manufactures all the parts used in these engines but is considering a proposal from an
external supplier who wishes to supply the starter assemblies used in these engines.
The starter assemblies are currently manufactured in Division 3 of Oxford Engineering. The
costs relating to the starter assemblies for the past 12 months were as follows:

Direct materials $200,000

Direct manufacturing labor 150,000
Manufacturing overhead 400,000
Total $750,000
Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for
each starter assembly is $5 ($750,000 ÷ 150,000).
Further analysis of manufacturing overhead revealed the following information. Of the total
manufacturing overhead, only 25% is considered variable. Of the fixed portion, $150,000 is
an allocation of general overhead that will remain unchanged for the company as a whole if
production of the starter assemblies is discontinued. A further $100,000 of the fixed overhead
is avoidable if production of the starter assemblies is discontinued. The balance of the current
fixed overhead, $50,000, is the division manager’s salary. If production of the starter
assemblies is discontinued, the manager of Division 3 will be transferred to Division 2 at the
same salary. This move will allow the company to save the $40,000 salary that would
otherwise be paid to attract an outsider to this position.

1. Tidnish Electronics, a reliable supplier, has offered to supply starter-assembly units at $4

per unit.Because this price is less than the current average cost of $5 per unit, the vice
president of manufacturing is eager to accept this offer. On the basis of financial
considerations alone, should the outside offer be accepted? Show your calculations. (Hint:
Production output in the coming year may be different from production output in the past
year.)
2. How, if at all, would your response to requirement 1 change if the company could use the
vacated plant space for storage and, in so doing, avoid $50,000 of outside storage charges
currently incurred? Why is this information relevant or irrelevant?

Solution:
1. The variable costs required to manufacture 150,000 starter assemblies are
Direct materials $200,000
Direct manufacturing labor 150,000
Variable manufacturing overhead 100,000
Total variable costs $450,000
The variable costs per unit are $450,000 ÷ 150,000 = $3.00 per unit.
Let X = number of starter assemblies required in the next 12 months.
The data can be presented in both ―all data‖ and ―relevant data‖ formats:

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The number of units at which the costs of make and buy are equivalent is
All data analysis: $340,000 + $3X = $200,000 + $4X
X = 140,000
or
Relevant data analysis: $190,000 + $3X = $50,000 + $4X
X = 140,000
Assuming cost minimization is the objective, then
• If production is expected to be less than 140,000 units, it is preferable to buy units from Tidnish.
• If production is expected to exceed 140,000 units, it is preferable to manufacture internally
(make) the units.
• If production is expected to be 140,000 units, Oxford should be indifferent between buying
units from Tidnish and manufacturing (making) the units internally.

2. The information on the storage cost, which is avoidable if self-manufacture is discontinued, is

relevant; these storage charges represent current outlays that are avoidable if self-manufacture is
discontinued. Assume these $50,000 charges are represented as an opportunity cost of the make
alternative. The costs of internal manufacture that incorporate this $50,000 opportunity cost are
All data analysis: $390,000 + $3X
Relevant data analysis: $240,000 + $3X
Alternatively stated, we would add the following line to the table shown in requirement 1 causing
the total costs line to change as follows:

The number of units at which the costs of make and buy are equivalent is
All data analysis: $390,000 + $3X = $200,000 + $4X
X = 190,000
Relevant data analysis: $240,000 + $3X = $ 50,000 + $4X
X = 190,000
If production is expected to be less than 190,000, it is preferable to buy units from Tidnish. If
production is expected to exceed 190,000, it is preferable to manufacture the units internally.

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Q No. 14:The Weaver Company produces gas grills. This year’s expected production is
20,000 units. Currently, Weaver makes the side burners for its grills.
Each grill includes two side burners. Weaver’s management accountant reports the
following costs for making the 40,000 burners:
Cost per Unit Costs for 40,000 Units

Direct materials $5.00 $200,000

Direct manufacturing labor 2.50 100,000
Variable manufacturing overhead 1.25 50,000
Inspection, setup, materials handling 4,000
Machine rent 8,000
Allocated fixed costs of plant administration, taxes, and insurance 50,000
Total costs $412,000
Weaver has received an offer from an outside vendor to supply any number of burners
Weaver requires at $9.25 per burner. The following additional information is available:
a. Inspection, setup, and materials-handling costs vary with the number of batches in which
the burners are produced. Weaver produces burners in batch sizes of 1,000 units. Weaver
will produce the 40,000 units in 40 batches.
b. Weaver rents the machine used to make the burners. If Weaver buys all of its burners
from the outside vendor, it does not need to pay rent on this machine.

Required
1. Assume that if Weaver purchases the burners from the outside vendor, the facility where
the burners are currently made will remain idle. On the basis of financial considerations
alone, should Weaver accept the outside vendor’s offer at the anticipated volume of 40,000
burners? Show your calculations.
2. For this question, assume that if the burners are purchased outside, the facilities where the
burners are currently made will be used to upgrade the grills by adding a rotisserie
attachment. (Note: Each grill contains two burners and one rotisserie attachment.) As a
consequence, the selling price of grills will be raised by $30. The variable cost per unit of the
upgrade would be $24, and additional tooling costs of $100,000 per year would be incurred.
On the basis of financial considerations alone, should Weaver make or buy the burners,
assuming that 20,000 grills are produced (and sold)? Show your calculations.
3. The sales manager at Weaver is concerned that the estimate of 20,000 grills may be high
and believes that only 16,000 grills will be sold. Production will be cut back, freeing up work
space. This space can be used to add the rotisserie attachments whether Weaver buys the
burners or makes them in-house. At this lower output, Weaver will produce the burners in
32 batches of 1,000 units each. On the basis of financial considerations alone, should Weaver
purchase the burners from the outside vendor? Show your calculations.

Solution:
1. Relevant costs under buy alternative:
Purchases, (40,000 x $9.25) $370,000
Relevant costs under make alternative:
Direct materials $200,000
Direct manufacturing labor 100,000
Variable manufacturing overhead 50,000
Inspection, setup, materials handling 4,000
Machine rent 8,000
Total relevant costs under make alternative $362,000

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The allocated fixed plant administration, taxes, and insurance will not change if Weaver makes or
buys the burners. Hence, these costs are irrelevant to the make-or-buy decision. The analysis
indicates that it is less costly for Weaver to make rather than buy the burners from the outside
supplier.

2. Relevant costs under the make alternative:

Relevant costs (as computed in requirement 1) $362,000
Relevant costs under the buy alternative:
Costs of purchases (40,000 x $9.25) $370,000
Additional fixed costs 100,000
Additional contribution margin from using the space
where the burners were made to upgrade the grills by
adding rotisserie attachments, 20,000 ($30 – $24) (120,000)
Total relevant costs under the buy alternative $350,000
Weaver should buy the side burners from an outside vendor and use its own capacity to upgrade
its grills.

3. In this requirement, the decision on making the rotisserie attachments is irrelevant to the
analysis because the rotisserie attachments increase operating income and they will be made
whether the burners are purchased or made.
Relevant cost of manufacturing burners:
Variable costs, ($5 + $2.50 + $1.25 = $8.75) x 32,000 $280,000
Batch costs, $100/batch* 32 batches 3,200
Machine rent 8,000
$291,200

Relevant cost of buying burners, $9.25 32,000 $296,000

*$4,000 40 batches = $100 per batch
In this case, Weaver should make the burners.

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