MAKE OR BUY

This is the situation where the company has the options or alternatives on whether it is worth
to produce its own product or it is cheaper if it just buys or outsource it from external supplier.

 Management often have to decide whether:

a. to buy from outside supplier
b. to make it internally

1. Urgent orders from customers

Why buy 2. Production bottlenecks e.g.
from Machine breakdown
outside 3. Limiting factor of production etc.
supplier?

1. Fear the suppliers may

not meet the delivery Why
date
don’t you
2. Unwilling to have buy from
idle capital
3. Wish to maintain outside
control over its supplier?
operations

 Therefore, to solve the Make or Buy decision, the management has to compare the
relevant cost of making and the relevant cost of buying. 

Relevant COMPARE
cost of Relevant cost of
making buying

When manufacturing the component displaces

existing productions, the lost contribution must
be added to the marginal cost of production of
the component before comparing it with the
buying in price.(Opportunity cost)
So which alternative should be chosen? The alternative that gives the
lowest relevant cost will be chosen.

The knowledge of relevant cost concept continues here…

 Avoidable cost
 Unavoidable cost

special
The above diagram gives the guideline on which cost item is relevant or not but
attention should be given to cost behavior (variable cost and fixed cost).

It is not
always guaranteed that the VC is relevant and FC is irrelevant. It still depends
on the criteria of a relevant cost which are:

1. The cost must be a future cost.

2. The cost must differ between the alternatives.
3. Must be cash item.
EXAMPLE 1

A firm manufactures a component XYZ-100 and the cost for the current production
level of 50,000 units are as follows:

Costs / unit
(RM)
Materials 2.50
Labour 1.25
Variable overheads 1.75
Fixed overheads 3.50
Total costs 9.00

Component XYZ -100 could be bought in for RM7.75 and if so, the production
capacity utilised at present will be unused. Assuming that there are no overriding
technical considerations, should XYZ 100 be bought in or manufactured?

SOLUTION

Workings:
Analysis of cost (Relevant or Irrelevant to Make or Buy decision)

Cost item Make Buy Remark (for reference only…not

part of the exam answer unless
required)
Direct material (RM2.50) √ - Material need to be bought so
future cost and differ

RELEVANT
Direct labour (RM1.25) √ - Labour cost need to be incurred in
Future and differ

RELEVANT
Variable OH (RM1.75) √ - Variable cost is to be incurred
based unit produce so future and
differ

RELEVANT
Fixed OH No information says that the FOH
can be changed

√ √ IRRELEVANT

Purchase price from - √ Purchases cost will be incurred if

supplier (RM7.75) the buy the component from the
supplier will not be incurred if
the company makes on its own.

Therefore it makes a difference

and RELEVANT
RELEVANT COST OF MAKING XYZ
RM
Materials 2.50
Labour 1.25
Variable overheads 1.75
.....................
5.50
========
RELEVANT COST OF BUYING XYZ
RM
Purchase price 7.75

.............
7.75
=====
Decision: Make because the co. will save ( 7.75-5.50 ) = _RM2.25

EXAMPLE 2: MAKE OR BUY WITH OPPORTUNITY COST

A firm is considering whether to manufacture or purchase a particular component ABC.

This would be in batches of 10,000 and the buying in price would be RM6.50 per unit.
The marginal cost/variable cost of manufacturing component ABC is RM4.75 per unit
and the component would have to be made on a machine which was currently
working at full capacity. If the component was manufactured, it is estimated that the
sales of finished product XY would be reduced by 1,000 units. XY has a marginal
cost of RM60.00 per unit and sells for RM80.00 per unit. Should the firm manufacture
or purchase component ABC?

Analysis:
Cost item Make Buy Remark
Vc manufacturing √ - Vc of manufacturing need to be incurred so
(RM4.75) future cost and differ

RELEVANT
Opportunity cost √ - These are the products that are going to be
(benefit of XX sacrificed if we make the component and
forgone) utilise the capacity.

(Lost on contribution So the company will lose the contribution

of XY) from product MM.
(RM 80 – RM 60) X OPPORTUNITY COST (benefit forgone)
1,000 units
This situation make a difference between
=RM20,000
the choices of make or buy.

RELEVANT
Purchase price - √ Purchases cost will be incurred if the
from supplier buy the component from the supplier
(RM7.75) will not be incurred if the company
makes on its own.

Therefore it makes a difference and

RELEVANT
SOLUTION

RELEVANT COST OF MAKING 10,000 units of ABC

RM
VC (RM4.75 X 10,000 units) 47,500
Opportunity cost
(Lost on contribution of XY) 20,000
(RM 80 – RM 60) X 1,000 units
Total costs 67,500

RELEVANT COST OF BUYING 10,000 units of ABC

RM
Purchase price 6.50 x 10,000 65000

Decision: BUY because the co. will save ( 67,500 - 65000 ) = _RM2,500

MAKE

- Whether the quality of the

- Whether the company product supplied is better
has the expertise and or at par with the
technical knowledge to - company’s product
make the product Can the product be
- Special resources may - delivered by the supplier
be required (material, on time?
machine, labour etc) to Brand name used by the
make the product supplier
- Can the company
guarantee the quality of
the product / component
to be manufactured
- Can the product be BUY
manufactured and
delivered on time
- Ability to produce the
quantity required
QUESTION 1 (Refer tutorial video)

A Perodua Executive in Malaysia is to decide whether the company should continue to

manufacture an engine component or purchase it from Zombie Corporation for
RM40.00 each since the demand of the engine component is decreased by 20% from
last year’s demand.
Last year’s production were 200,000 units with the following cost:
RM
Direct material 4,000,000
Direct labour 1,600,000
Variable manufacturing OH 800,000
Fixed manufacturing OH 2,000,000

The following situations are to be considered:

 New stock of material need to be purchased and the unit cost for direct material will
increase by 10% from last year.
 Direct labour will be paid based on hours worked on job.
 If Perodua buys the components, 40% of the fixed costs will be avoided. The other
60% will continue regardless of whether the engine components are manufactured or
purchased.
 Variable overhead varies with output volume.
 The current supplier’s price is revised to RM42 per component.
 Adjustment need to be made in production schedule if the component is continue to be
made internally which resulted to the decrement in the other product MM produced by
the company by 3,000 units. This product can be sold at RM25 with a variable cost of
RM18 per unit.

Required:

a. Calculate opportunity cost from product MM sacrificed.

b. Calculate relevant cost of making engine component.
c. Calculate relevant cost of buying engine component.
d. Advise whether Perodua should make or buy the engine component.
QUESTION 2
Genuang Generator Sdn. Bhd. manufactures small electric motors for which a small
parts is needed. The following cost data have been accumulated for the 16,000 parts
that the company manufactured during the previous year.
RM
Direct material 32,000
Direct labour 88,000
Variable manufacturing overhead 72,000
Fixed manufacturing overhead 112,000
The company can buy the parts from another firm for RM19.00 per unit. If the
company buys the item, it will be able to reduce fixed manufacturing overhead costs
by RM60,000 per year. It will also be able to rent some of the facilities currently
used to make parts to another company for RM40,000.
Required:
a. Should the company continue to make the parts (16,000 units), or should it be
purchased from the other firm?
b. Briefly explain four (4) qualitative factors which are significant for make or
buy decision.

QUESTION 3
SENTOSA Bhd. uses component MM in its products. At present, the components are
bought from an outside supplier at RM26 per unit. The company plans to make the
component internally. Component MM would take 4 hours and involved the following
cost:
RM
Direct material 6.00
Direct labour 4.00
Production overhead:
Variable 5.00
Fixed 2.50
To manufacture the component MM would involve work on a machine that is currently
being used to make product CC which takes 3 hours per unit. If the machine is used to
produce component MM, a number of product CC have to be sacrificed. Production
cost per unit of product CC is:
RM
Direct material 13.00
Direct labour 7.50
Production overhead:
Variable 9.00
Fixed 4.50
Selling price per unit RM44.00
Required:
a. Let say, SENTOSA Bhd. needs 6,000 units of component MM next month and it is
agreed by the outside supplier. Should SENTOSA Bhd. make the component
internally or buy from the supplier?
b. List three (3) factors that to be considered when making a “MAKE” decision
and three (3) factors to be considered when making a “BUY” decision.

QUESTION 4

Syarikat Dengar-Dengar manufactures radio set which sells at RM480 per unit. The
variable costs of one unit of radio are given below:
RM
Direct material 150
Direct labour 100
Variable manufacturing overhead 130

One of the components used in the radio set has been supplied by an electronic
company at RM45 per unit. Syarikat Dengar-Dengar was told that due to increase in
inflation the purchase price of the component is to be increased to RM50 in the future.

The management is considering to make the component using its own capacity. If the
component is manufactured, due to limited raw material, sales and production of 150
units of radio set will be cancelled in order to allow the raw material to be used to
manufacture 12,000 units of component.

The variable cost of making one component is as follows:

` RM
Direct material 20
Direct labour 15
Variable manufacturing overhead 11

Syarikat Dengar-Dengar will allocate RM45,000 of its common fixed costs to the
component if it is manufactured. A special machine will have to be rented at a cost of
RM27,000 in order to make the component. After looking at the information provided,
one of the managers suggest that the company should continue buying the component
since the cost of making is RM52 per unit (VC/unit + FC/unit + average rent/unit) as
compared to cost of buying RM50.

Required:

As the management accountant of the company, do you agree with the manager’s
suggestion? Why? (Show all workings)
QUESTION 5

Protom Engineering Sdn. Bhd. manufactures small engines. The engines are sold to
manufacturers who install them into water pumps. The company currently manufactures
all starters in these engines but is considering a proposal from an external supplier
who wishes to supply the starters.

The starters are currently manufactured in Division C of Protom Engineering. The data
relating to Division C for the last three months were as follows:
RM’000
Direct material 100
Direct labour 75
Manufacturing Overhead 200
----------
Total manufacturing costs 375
=====
Units produced 75,000 units
Cost per unit RM5 per unit

Further analysis of factory overhead revealed the following information:

Out of the total factory overhead reported, only 25% is considered variable. Of the
fixed cost, RM75,000 is an allocation of general overhead that would remain
unchanged if production of the starters are abandoned. A further RM50,000 of the
fixed overheads is avoidable if the starters are no longer manufactured. The balance
of fixed overhead, RM25,000 is the Division C manager’s salary.

If the manufacture of the starters discontinued, the manager of Division C will be

transferred to Division B at the same salary. This would allow the company to save
RM20,000 salary that would otherwise be paid to attract an outsider to the position.

External supplier has offered to supply the starters at RM4 per unit. Since the price is
less than the current average cost, the Vice-President of the company is eager to
accept the offer.

Required:

a. Calculate total variable costs per unit of the starter.

b. What will be your advice to the offer made by the external supplier, if the
level of manufacturing volume be:
i. 65,000 units
ii. 95,000 units

c. If the company can use the vacated factory space for storage, it will avoid
RM25,000 of outside storage charges. How would this effect your decision in
(b)?