Make Or Buy Decisions

Make Or Buy Decisions

A Company may be producing a product by itself or receive an offer from an outside supplier to supply that product. Similarly, a firm may be buy a product from outside or may make/produced/manufacture that product in the firm itself.

Such problem of make or buy be faced by companies which produce the goods assembling various sort of components parts like Television, Motor car, Watch, Computer etc. manufacturing companies. Make-or-buy decisions are not short-run in nature but fall into the small-scale tactical decision category. 

The decision to make or buy may be motivated by cost leadership and/or differentiation strategies. Making instead of buying or buying instead of making may be one way of reducing the cost of producing the main product. Alternatively, choosing to make or buy may be a way of increasing the quality of the component and thus increasing the overall quality of product.

A company has to take make or buy decision when it has to face following choices:
i. Buy certain part or sub-assemblies from outside suppliers, or
ii. Use available capacity to produce the item within the factory.

Cost analysis for make or buy is necessary. The decision in such case will be made by comparing the price being paid to outsides and all additional costs that will have to incurred for manufacturing the product. This type of make or buy decision should be made only after a proper analysis that compares manufacturing costs with purchasing costs and assess the best used of the available facilities. Consideration of a 'Make' option automatically implies that the company has the available capacity for that purpose or has considered the cost of obtaining the necessary capacity in the decision analysis.




Relevant Information Regarding Make Or Buy Decisions Are As Follows:
- Incremental production cost for each unit
- Unit cost of purchasing from outside supplier
- Number of available suppliers
- Quantity of production capacity available to manufacture components
- Opportunity costs of using facilities for production rather than for other purposes
- Quality for space available for storage
- Costs associated with carrying inventory
- Increase in through put generated by buying components.

This problem occurs when the management is contemplating whether a component part used in the production of a main product should be manufactured internally or purchased from outside supplies.

Question:

The management of ABC ltd is considering next year budget. One of the components produced by the company which is incorporated in another product before being sold has the manufacturing costs as follows:

COSTS                                                  $

direct materials                                           14

direct labour                         (4 hours x $3) 12

variable overhead                 (4 hours x $2)   8

fixed overhead                      (4 hours x $5)  20

                                                               54       

XYZ ltd has offered to supply their variable components at a guaranteed price of $50 per unit. 

You are required to advice the management of ABC whether the components should be purchased or produced internally.

Solution

Cost of making                                $

direct materials                                14

direct labour                                     12

variable overhead                               8 

                                                         34  

The variable cost of producing the components is $34 while the purchase price is $50.

Advice: ABC ltd should make the components internally