LEARNING OBJECTIVE 3

Prepare a make or buy

analysis.
THE MAKE OR BUY DECISION

When a company is involved in more than

one activity in the entire value chain, it is
vertically integrated. A decision to carry
out one of the activities in the value chain
internally, rather than to buy externally
from a supplier is called a “make or buy”
decision.
VERTICAL INTEGRATION-
ADVANTAGES
Smoother Flow of parts
and materials

Better quality control

Realize profits
VERTICAL INTEGRATION -
DISADVANTAGE
• Companies may fail to take advantage of suppliers who can
create economies of scale advantage by pooling demand
from numerous companies.
• While the economics of scale factor can be appealing, a
company must be careful to retain control over activities that
are essential to maintaining its competitive position.
THE MAKE OR BUY DECISION: AN
EXAMPLE
Per Unit 8.000 Units

Direct material $6 $ 48.000

Direct labor 4 32.000
Variable overhead 1 8.000
Supervisor’s salary 3 24.000
Depreciantion of special equipment 2 16.000
Allocated general overhead 5 40.000
Total cost $21 $ 168.000
 Total relevants cost - 8.000 units
EXHIBIT 14-10
Make Buy

Direct material (8.000 unit X $6 per unit) $48.000

Direct labor (8.000 unit X S4 per unit) $32.000

Variable overhead (8.000 units X $1 per unit) $8.000

Supervisor salary $24.000

Depreciation of special equipment (not Relevant)

Allocated general overhead (not relevant)

Outside purchase price $152.000

Total cost $112.000 $152.000

$ 40.000
Difference in favor of continuing to make

Because it costs $ 40.000 less to make the shifters internally than to buy them from the oustide supplier,
Mountain Goat Cycles should reject the outside supplier’s offer.
OPPORTUNITY COST

An opportunity cost is the benefit that is foregone as a

result of pursuing some course of action.
Opportunity costs are not actual cash outlays and are not
recorded in the formal accounts of an organization.
 To, illustrate, assume that the space now being used to produce shifter could be used to produce a new
cross-country bike that would generate a segment margins of $60.000 per year:

Make Buy

Total annual cost (see exhibit 14-10 $112.000 $152.000

Opportunity cost-segment margin forgone on a potential new product line $60.000

Total relevant cost $172.000 $152.000

difference in favor of purchasing from the outside supplier $ 20.000

VALUE TO BUSINESS (DEPRIVAL VALUE)
Deprival value
= Lower of

Replacement Cost Recoverable Value

(RC) (RV)
= Higher of

Net Realizable Value Economic Value

(NRV) (EV)
 Opportunity Cost: Deprival Value Approach

• RV : $10 Deprival value

• NRV : $12 = Lower of $10

• EV : $15

Replacement Cost Recoverable Value

(RC) (RV) $15
$10 = Higher of

Net Realizable Value Economic Value

(NRV) (EV)
$12 $15
LEARNING OBJECTIVE 4

Prepare an analysis
showing whether a special
order should be accepted
KEY TERMS AND CONCEPTS
A special order is a one-time When analyzing a special
order that is not considered order, only the incremental
part of the company’s normal costs and benefits are
ongoing business. relevant.
Since the existing fixed
manufacturing overhead costs
• The minimum price in the concept of
relevant costing is defined as covering would not be affected by the
all the incremental cost, icluding order, they are not relevant.
opportunity cost if applicable, that
would be incurred for an order. The
minimum price is the rock bottom
price if anything below this minimum
price is accepted the company will
suffer a loss
 SPECIAL ORDER
• Mountain Goat Cycles has just received a requwst from the Seattle Police Department
produce 100 specially modifed mountain bikes at a price $558
• The normal selling price of the city of yhe city cruiser bike is $689, and its unit product cost is
$564 as shown below:
Direct materials $372
Direct labor $90
Manufacturing overhead $102
Unit Product Cost $564

• Variable manufacturing overhead $12

• Special Modification $34
• In additiona, the company would have to pay a grapihics design studio $2.400 to design and cut
stencils.
EXHIBIT 14-13

Per Unit Total 100 Bikes

Incremental revenue $558 $55.800

Less incremental cost:

Variable costs:

Direct materials $372 $37.200

Direct labor $90 $9.000

Variable manufacturing overhead $12 $1.200

Special modifications $34 $3.400

Total variable cost $508 $50.800

fixed cost:

Purchase of stencils $2.400

Total incremental cost $53.200

Incremental net operating $2.600

UTILIZATION OF A CONSTRAINED
RESOURCE
• The Theory of Constraints (TOC) is based on the
affectively managing the constraint is a key to success,