Answer:
In this case, an analyst is presented with recommending the best option between internal production and external acquisition of goods (outsourcing) for resale. Through relevant quantitative and qualitative analyses it will be decided whether the company should make or buy the engines or vacuums. To make 50,000 units of the engines, production costs will be incurred as given in the question.
After considering the qualitative factors, including availability of production capacity, space, and labor, the next would be to undertake a costs /benefits quantitative analysis of making the engines in-house versus buying from outside for resale. The outcomes are then compared to understand their financial effects. The option that makes better financial sense or that is more profitable should be chosen because the payoff outweighs the other and the company's assets and stockholders will be better off with the more profitable option, either in the direction of making more profits or reducing the cost profile.
In any make or buy decision situation, the costs that are relevant are the costs that change with the option. Any costs that do not change with a chosen option is disregarded. This include items like depreciation and other indirect fixed costs.
b) Computations:
1. To make:
Description Cost per Month
Direct Materials $75,000
Direct Labor $100,000
Variable factory overhead $375,000 ($7.50 x 50,000)
Total variable costs = $550,000
Selling price = $7,500,000 ($150 x 50,000)
Contribution = $6,950,000
Fixed factory overhead $150,000 (150% of $100,000)
Net Income $6,800,000
2. To buy:
Cost of goods - $3,000,000
Selling price $7,500,000
Contribution $4,500,000
Fixed costs $112,500 (75% of $150,000)
Net Income $4,387,500
c) The company should go ahead and produce the engines internally. This is far more profitable, all quantitative factors considered.
Explanation:
In arriving at a decision in a make or buy decision situation, only relevant costs that change with the option should be analysed. Fixed indirect costs and depreciation should not be considered.
From the above quantitative analyses, the company will make a contribution (profit) of $6.95 million instead of $4.5 million if it chooses to make the engines internally.
Even a review of the bottomline (after factoring in the fixed costs) shows that the company would make a net income of $6.8 million by producing the engines in-house. The net income above the buy option is more than $2 million.
