MAKE VS BUY
WEEK 10
ILLUSTRATIVE QUESTIONS
Q 11.2 Maxitank
makes two products.
Its costs are:
Product R
Product S
Selling price
$12
$20
Materials
$4
$11
Labour
hours
2
4
Machine
hours
4
3
Maxitank’s sales are
limited by the bottleneck
(machine) capacity of the
factory. Which of the two
products should be
produced first in order to
maximize the throughput
contribution generated
from the limited capacity?
Solution 11.2
Product R
Product S
Selling price
$12
$20
Materials
$4
$11
Throughput
contribution
$8
$9
Machine hours
4
3
Return per machine
hour
$2
$3
Ranking
2
1
Labour hours are irrelevant for throughput
VARIATION TO Q11.2
Maxitanks’ cost of
labour is now
included:
Product R
Product S
Selling price
$12
$20
Materials
$4
$11
Labour cost
$2
$5
Labour
hours
2
4
Which of the two
products should be
produced first in
order to maximize the
profits generated
from the limited
capacity, taking
material and labour
costs into account?
Solution 11.2
Product R
Product S
Selling price
$12
$20
Materials
$4
$11
Labour
$2
$5
Contribution
$6
$4
Labour hours
2
4
Return per machine
hour
$3
$1
Ranking
1
2
Q 11.5
Harrison products capacity is 20,000 units per year. Their
results for last year are:
Sales 12,000 units @ $100
Variable costs
Contribution margin
Fixed costs
Profit
$1,200,000
588,000
612,000
245,000
$367,000
Harrison expects its regular sales next year to be 15,000 units. They
also expect fixed costs to increase by $100,000. A foreign distributor
has offered to buy a guaranteed 8,000 units at $95 per unit next year
and the company can produce on the maximum capacity. Should
Harrison accept this offer?
SOLUTION 11.5
Regular sales
Sales 15,000 units @ $100
Sales 12,000 @ $100
plus 8,000 @ $95
Special order
$1,500,000
$1,200,000
760,000
Variable costs 15,000 @ $49
20,000 @ $49
735,000
Contribution margin
765,000
980,000
Fixed costs
345,000
345,000
$420,000
$635,000
Profit
980,000
OPERATING DECISIONS & RELEVANT COSTS




Relevant costs are those
that are relevant to a
particular decision.
Relevant costs are the
future, incremental cash
flows that result from a
decision
Sunk costs are not
relevant
Relevant costs are
avoidable costs.


Unavoidable costs are not
relevant because,
irrespective of what a
decision is, unavoidable
costs will still be incurred
Relevant costs may be
opportunity costs

the loss of a future cash
flow that takes place as a
result of making a
particular decision
APPLYING RELEVANT COSTS

Make versus buy: Outsourcing decisions


Equipment replacement


Fixed costs are not relevant
Sunk costs and depreciation are not relevant
Relevant cost of materials
Material purchased specifically - relevant cost is the
purchase price
 Material already in stock and used regularly relevant cost is the replacement price
 Material already in stock but surplus - relevant cost is
the opportunity cost


Higher of scrap value or its value in any alternative use
RELEVANT COSTS: MAKE V. BUY
Table 11.4: Relevant costs - make versus buy
Stationery
10,000 @ $0.50
Labour
10,000 @ $2
Share of depreciation costs
Outsourcing cost
Total relevant cost
Cost to make
5 ,0 0 0
Cost to buy
20,000
10,000
$35,000
10,000
20,000
$30,000
Table 11.5: Relevant costs - make versus buy – simplified
Stationery
10,000 @ $0.50
Labour
10,000 @ $2
Outsourcing cost
Total relevant cost
Relevant cost to make
5 ,0 0 0
Relevant cost to buy
20,000
$25,000
20,000
$20,000
EQUIPMENT REPLACEMENT
Table 11.6: Relevant costs – equipment replacement
Retain old kitchen
Purchase price of new kitchen
Trade-in value of old machine
Operating costs
$40,000 p.a x 5 years
$30,000 p.a. x 5 years
Additional income from dining
of $25,000 p.a. x 5 years
Total relevant cost
Buy new kitchen
-$150,000
+$25,000
-$200,000
-$150,000
+$125,000
-$200,000
-$150,000
Q 12.4

Cirrus Company has
calculated that the
cost to make a
component is made up
of materials $120,
labour $60, variable
overhead $30 and
fixed overhead of $25.
Another company has
offered to make the
component for $140.

If the company has
spare capacity and
wishes to retain its
skilled labour force,
should it make or buy
the component?