- Identify the data needed to support a make or buy decision
So we talked previously about a make or buy decision with Hupana and the soles of their shoes. Sometimes a second example is helpful, so let’s take a look at another shoe company! Snazzy Jazzi is thinking about buying laces for their shoes instead of making them. Let’s take a look at their decision making process:
Let’s revisit our Hupana scenario:
Hupana currently buys the soles that go on their awesome running shoes from a supplier premade and ready to attach to their shoes. The supplier is charging $5.00 per sole. Hupana wants to look at the option of making the soles in house, because they have some empty space in their building, that would be a perfect fit for the equipment needed to make the soles. Just to make this simple, let’s assume Hupana already owns the equipment to make the soles.
We know that Hupana makes 2,000 pairs of shoes per year. So they pay their supplier $10,000 for the premade soles.
Let’s take a look.
|Difference in favor of MAKING||$400|
|Hupana Make or Buy Decision|
|Relevant Costs: Make||Relevant Costs: Buy|
|Direct Materials ($2.50 per sole × 2000 soles)||$5,000.00|
|Direct Labor (.1hr/sole at $20/hour)||$4,000.00|
|Variable Overhead (.1hr/sole at $3/hour x 2000 soles)||$600.00|
|Depreciation of equipment (not relevant)|
|Allocation of fixed overhead (not relevant)|
|Cost of buying||$10,000.00|
So if the space we would use to make the soles is sitting idle right now, then, this analysis would suggest we should start to make the soles in house, right?
But what if the space used to make the soles, could also be used to expand to add another line of shoes? And what if, that additional line of shoes would add $5000 to the net income of the company?
|Difference in FAVOR of continuing to buy from the supplier||$4,600|
|Total annual cost||$9,600.00||$10,000.00|
|Opportunity Cost-Additional Shoe Line||$5,000.00|
So did that change the plan? Yes—Hupana would be better off adding a shoe line, and continuing to purchase their soles from their supplier!
Knowing what you know now about relevant costs, might there be some additional items you would ask about in this scenario? I can think of at least one!
If they add a shoe line, they will need more soles for the shoes! What if the supplier was willing to lower the price per sole with the higher quantity? That could save the company even more money by adding the line and continuing to purchase soles from their supplier!
But on the other hand, what if the supplier cannot make soles for the new line, as they are at capacity, how might this affect the opportunity cost of the new line?
There are, as we have discussed, so many variables to each decision we make. The examples are simplified, but think through some of the other situations that may arise with each decision you are asked to make!
- Make or Buy Decisions. Authored by: Freedom Learning Group. Provided by: Lumen Learning. License: CC BY: Attribution
- Part 4 - Relevant Costs for Decision Making - Make or Buy. Authored by: Tony Bell. Located at: https://www.youtube.com/watch?v=9ILpNPml17s&feature=youtu.be. License: All Rights Reserved. License Terms: Standard YouTube License