Make or Buy Decision Approach: Simple Cost Analysis
Simple Cost Analysis
The
concept is illustrated using an example problem.
Example Problem for Simple Cost Analysis
A
company has extra capacity that can be used to produce a sophisticated fixture
which it has been buying for Rs. 900 each. If the company makes the fixtures,
it will incur materials cost of Rs. 300 per unit, labour costs of Rs. 250 per
unit, and variable overhead costs of Rs. 100 per unit. The annual fixed cost
associated with the unused capacity is Rs. 10,00,000. Demand over the next year
is estimated at 5,000 units. Would it be profitable for the company to make the
fixtures?
Given data
Purchasing cost per unit = Rs. 900
Material cost per unit = Rs. 300
Labour cost per unit = Rs. 250
Overhead cost per unit = Rs. 100
Fixed cost associated with unused
capacity = Rs. 10,00,000
Total No. of units = 5000
Solution
Cost to make
Variable cost per unit = Material cost + Labour cost +
Overhead cost
= 300 + 250 + 100
= Rs. 650
Total variable cost = Total units * Variable cost
per unit
= 5000 * 650
= Rs. 32,50,000
Total cost = Total variable cost + Fixed cost associated with unused
capacity
= 32,50,000 + 10,00,000
= Rs. 42,50,000
Cost to buy
Total purchase cost = Total units * Buying cost per unit
= 5,000 * 900
= Rs. 45,00,000
Total cost = Total purchase cost + Fixed cost associated with unused
capacity
= 45,00,000 + 10,00,000
Total cost = Rs. 55,00,000
Decision
The cost of making fixtures
is less than the cost of buying fixtures from outside. Therefore, the
organization should make the fixtures.