MAKE VS BUYWEEK 10

Product R Product S

Selling price $12 $20

Materials $4 $11

Labour hours

2 4

Machine hours

4 3

ILLUSTRATIVE QUESTIONS

Q 11.2 Maxitank makes two products. Its costs are:

Maxitank’s sales are limited by the bottleneck (machine) capacity of the factory. Which of the two products should be produced first in order to maximize the throughput contribution generated from the limited capacity?

Product R Product S

Selling price $12 $20

Materials $4 $11

Throughput contribution

$8 $9

Machine hours 4 3

Return per machine hour

$2 $3

Ranking 2 1

Labour hours are irrelevant for throughput

Solution 11.2

Product R Product S

Selling price $12 $20

Materials $4 $11

Labour cost $2 $5

Labour hours

2 4

VARIATION TO Q11.2

Maxitanks’ cost of labour is now included:

Which of the two products should be produced first in order to maximize the profits generated from the limited capacity, taking material and labour costs into account?

Product R Product S

Selling price $12 $20

Materials $4 $11

Labour $2 $5

Contribution $6 $4

Labour hours 2 4

Return per machine hour

$3 $1

Ranking 1 2

Solution 11.2

Q 11.5

Sales 12,000 units @ $100 $1,200,000

Variable costs 588,000

Contribution margin 612,000

Fixed costs 245,000

Profit $367,000

Harrison products capacity is 20,000 units per year. Their results for last year are:

Harrison expects its regular sales next year to be 15,000 units. They also expect fixed costs to increase by $100,000. A foreign distributor has offered to buy a guaranteed 8,000 units at $95 per unit next year and the company can produce on the maximum capacity. Should Harrison accept this offer?

SOLUTION 11.5

Regular sales Special order

Sales 15,000 units @ $100Sales 12,000 @ $100plus 8,000 @ $95

$1,500,000$1,200,000

760,000

Variable costs 15,000 @ $4920,000 @ $49

735,000980,000

Contribution margin 765,000 980,000

Fixed costs 345,000 345,000

Profit $420,000 $635,000

OPERATING DECISIONS & RELEVANT COSTS

Relevant costs are those that are relevant to a particular decision.

Relevant costs are the future, incremental cash flows that result from a decision

Sunk costs are not relevant

Relevant costs are avoidable costs.

Unavoidable costs are not relevant because, irrespective of what a decision is, unavoidable costs will still be incurred

Relevant costs may be opportunity costs the loss of a future cash

flow that takes place as a result of making a particular decision

APPLYING RELEVANT COSTS Make versus buy: Outsourcing decisions

Fixed costs are not relevant Equipment replacement

Sunk costs and depreciation are not relevant Relevant cost of materials

Material purchased specifically - relevant cost is the purchase price

Material already in stock and used regularly - relevant cost is the replacement price

Material already in stock but surplus - relevant cost is the opportunity cost Higher of scrap value or its value in any alternative

use

RELEVANT COSTS: MAKE V. BUY

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SSttaattiioonneerryy 1100,,000000 @@ $$00..5500

55,,000000

LLaabboouurr 1100,,000000 @@ $$22

2200,,000000

SShhaarree ooff ddeepprreecciiaattiioonn ccoossttss 1100,,000000 1100,,000000 OOuuttssoouurrcciinngg ccoosstt 2200,,000000 TToottaall rreelleevvaanntt ccoosstt $$3355,,000000 $$3300,,000000

TTaabbllee 1111..55:: RReelleevvaanntt ccoossttss -- mmaakkee vveerrssuuss bbuuyy –– ssiimmpplliiffiieedd RReelleevvaanntt ccoosstt ttoo mmaakkee RReelleevvaanntt ccoosstt ttoo bbuuyy

SSttaattiioonneerryy 1100,,000000 @@ $$00..5500

55,,000000

LLaabboouurr 1100,,000000 @@ $$22

2200,,000000

OOuuttssoouurrcciinngg ccoosstt 2200,,000000 TToottaall rreelleevvaanntt ccoosstt $$2255,,000000 $$2200,,000000

EQUIPMENT REPLACEMENT

TTaabbllee 1111..66:: RReelleevvaanntt ccoossttss –– eeqquuiippmmeenntt rreeppllaacceemmeenntt RReettaaiinn oolldd kkiittcchheenn BBuuyy nneeww kkiittcchheenn

PPuurrcchhaassee pprriiccee ooff nneeww kkiittcchheenn --$$115500,,000000 TTrraaddee--iinn vvaalluuee ooff oolldd mmaacchhiinnee ++$$2255,,000000 OOppeerraattiinngg ccoossttss $$4400,,000000 pp..aa xx 55 yyeeaarrss $$3300,,000000 pp..aa.. xx 55 yyeeaarrss

--$$220000,,000000

--$$115500,,000000 AAddddiittiioonnaall iinnccoommee ffrroomm ddiinniinngg ooff $$2255,,000000 pp..aa.. xx 55 yyeeaarrss

++$$112255,,000000

TToottaall rreelleevvaanntt ccoosstt --$$220000,,000000 --$$115500,,000000

Q 12.4

Cirrus Company has calculated that the cost to make a component is made up of materials $120, labour $60, variable overhead $30 and fixed overhead of $25. Another company has offered to make the component for $140.

If the company has spare capacity and wishes to retain its skilled labour force, should it make or buy the component?