Mastery Problem: Cost-Based Decision Making - Make or Buy Decisions

Differential Analysis: Make or Buy

Managers must often decide between two or more alternatives. Differential analysis is used in decision making. When using differential analysis, it is important to only include those amounts that are different between the alternatives. Differential cost is subtracted from differential revenue to determine differential income/loss.

When calculating differential cost, the only costs that should be included are_____________:

For example, manufacturing companies often assemble components into a finished product. These components can be purchased from a supplier or produced within the company. The decision to produce the component or buy it is often referred to as a make-or-buy decision and uses differential analysis to assist in the decision-making process.

Differential analysis is only one step in deciding to make or buy the product. Management must also take into consideration nonquantitative data. If the company has been making the product, will it lay off employees if it starts buying the product? If so, will this hurt the companys reputation? If parts required for making the components will be obtained from an outside source, is that source reliable? These nonquantitative issues will influence the success or failure of a make-or-buy decision.

APPLY THE CONCEPTS: Calculating per-unit manufacturing cost in a make-or-buy decision

Global Corporation, a high-end digital camera manufacturer, currently purchases a component part from an outside company at a price of $125 per unit. While the quality of the component has always been very high, Global Corporations management believes it might be possible to produce a superior component internally at a cost lower than $125. The accounting department has provided an estimate of the per-unit manufacturing cost of the component.

Direct materials	46
Direct labor	39
Variable factory overhead	23
Fixed factory overhead	20
	$128

The companys controller believes that the estimate may be incorrect, because Global Corporation has excess manufacturing capacity to produce the components without incurring additional fixed factory overhead. What per-unit manufacturing cost should be used in determining whether Global Corporation should purchase the components from an outside company or manufacture them internally? $___________

APPLY THE CONCEPTS: Calculating differential income in a make-or-buy decision

Complete the table below to compare the per-unit cost for Global Corporation to make the component and the per-unit cost to buy the component.

Make or Buy Decisions
Purchase price of an instrument panel		$
Differential cost to manufacture:
Direct materials	$
Direct labor
Variable factory overhead
Cost savings from manufacturing an instrument panel		$

Based on your analysis, it is better for Global Corporation to _____ the component. Doing so will save the company $ per unit.______