Management Accounting – Case Study: Make or Buy Decisions

Management Accounting – Case Study
Make or Buy Decisions

Introduction:
This case study is an attempt to understand the make and buy decisions for a firm. Make
and buy decision is a strategic decision for the firm where they need to choose between
producing an item internally or buying it externally from other suppliers (Inman, 2018). We
can work on a rule of thumb for out-sourcing wherein a firm should not outsource under the
following three conditions: (Burt, Dobler, and Starling, 2003)
 The sub part is a critical path item in the production line
 The item is a specially designed for the firm
 The item is a core competency of the firm.
Many a times these industries require sub parts which they can either choose to produce or
buy, this decision of choosing between producing the product at own units or buying it from
other concern or outside suppliers is popularly known as the making or buying decision.
Making or buying is a decision which requires understanding the relevant cost of the
transaction for the concern. Strategizing in the business world ultimately boils down to the
undertaking of the make-or-buy-or-cooperate decisions of the firm. (Sousa, 2012)
These decisions for firms are based on two factors namely, Qualitative and Quantitative.
(Wilkinson, 2013):
 Qualitative factors include ensuring the quality of the products and at the same time
maintaining healthy relationship to keep the supplies continuous.
 The quantitative features involve analysing the cost of both the alternative and
picking up the one which is less costly for the firm.
Thus, we see that the cost analysis should be carried out using the relevant cost approach. The
relevant costs are those costs which can be avoided if we choose to buy the product from an

outside supplier. Examples of this relevant cost are the cost of material, labour and variable
manufacturing overheads.
Approach to the Problem:
Here, the firm can make the product - sub assembly component in-house or can purchase it
directly from an outside supplier. The approach is to assess the relevant cost of both these
options and choose the lower cost option:
 Option 1: Continue to make the sub assembly component in house
 Option 2: Buy it from the supplier @ $16 per component
Solution:
Analysis of Make or Buy decision
Cost Head Per unit Total for 8,000 units
Make Buy Make Buy
Purchase Price $0 $16 $0 $1,28,000
Direct Material $5 $40,000
Direct Labor $4 $32,000
Variable Factory Overhead apply $4 $32,000
Fixed Overhead that can be avoided by buying $2 $16,000
Total Relevant Cost $15 $16 $1,20,00
0 $1,28,000
Difference in Favor of making the product $1 $8,000
Fixed Overheads:
Total Fixed Overheads applied $6
Fixed Overhead Which continues to apply (2/3) $4
Fixed Overhead that can be avoided by buying $2
Recommendation:
The firm should continue to make the sub-assembly component in-house as that would cost
lower, than purchasing it from the outside suppliers.
Explanation: