Examples of Make or buy Decision

Make or Buy Decision

	Product A	Product B
Sale price	100	120
Variable Cost	80	100
Incremental Fixed cost	8000	5000
Unit to produced	5000 unit	5000 units
Supplier offer	90	90

Suggest company should buy or make the products.

Solution

1. Cost can be saved on making product

	Product A	Product B
Variable Cost of making	80	100
units	5000	5000
Variable cost saved	40,000	50,000
Incremental fixed cost	8,000	5,000
	48,000	55,000

2. Cost will be required to buy

	Product A	Product B
Variable Cost of making	90	100
units	5000	5000
Variable cost of buying	45,000	45,000

3. Differential Cost

	Product A	Product B
Cost of making Saved	(48,000)	(55,000)
Cost of buying	45000	45000
Variable cost of buying	(3,000)	(10,000)

Both products should be sub contracted because the cost offered by the supplier is less than cost saved by not making the product.

 If cost of supplier would be more than cost saved by not making the product then it would be a making case.

Example of Contribution as Relevant Cost

Example of Contribution as Relevant Cost

Item	Hour	Rate
Labour (Scare)	4000	10
Variable overhead	5000	5
Fixed overhead			8000

Labour hour can be use another job which will earn a contribution of 8 per unit. Whether Alam & company should select the job at a price 100,000.

Solution

item	Hour	Rate	Amount	Total
Price offered				100,000
Labour	4000	10	40,000
Variable overheads	5000	5	25,000
Fixed Cost	Not relevant
Contribution	2000	8	16,000
Total Cost			81,000	(81,000)
Profit				19,000

Important points

1.       Fixed cost is irrelevant cost

2.       Labour overheads and variable overheads are relevant cost because contribution is calculated after deducting the labour and variable cost otherwise contribution would be much higher and would be required to add the higher contribution as opportunity cost.

The job should be opted because it will bring additional contribution of 19,000 as calculated above.