Exercise 3.

10 Make-or-Buy, Traditional and ABC Analysis

Brees, Inc., a manufacturer of golf carts, has just received an offer from a supplier to provide
2,600 units of a component used in its main product. The component is a track assembly that is
currently produced internally. The supplier has offered to sell the track assembly for $66 per
unit. Brees is currently using a traditional, unit-based costing system that assigns overhead to
jobs on the basis of direct labor hours. The estimated traditional full cost of producing the track
assembly is as follows:
Direct materials S40.00
Direct labor $ 16.50
Variable overhead $4.50
Fixed overhead $40.00
Prior to making a decision, the company's CEO commissioned a special study to see whether
there would be any decrease in the fixed overhead costs. The results of the study revealed the
following
3 setups- $1,160 each (The setups would be avoided, and total spending could be reduced by
$1,160 per setup.)
One half-time inspector is needed. The company already uses part-time inspectors hired
through a temporary employment agency. The yearly cost of the part-time inspectors for the
track assembly operation is $12,300 and could be totally avoided if the part were purchased.
Engineering work: 470 hours, $45/hour. (Although the work decreases by 470 hours, the
engineer assigned to the track assembly line also spends time on other products, and there
would be no reduction in his salary.)
75 fewer material moves at $30 per move.
Required:
1. Ignore the special study. and determine whether the track assembly should be produced
internally or purchased from the supplier.
2. Now, using the special study data, repeat the analysis.
3. Discuss the qualitative factors that would affect the decision, including strategic implications.
4. After reviewing the special study, the controller made the following remark: "This study
ignores the additional activity demands that purchasing would cause. For example, although
the demand for inspecting the part on the production floor decreases, we may need to inspect
the incoming parts in the receiving area. Will we actually save any inspection costs?" Is the
controller right?
Exercise 17.10
1. Make Buy
Direct materials.................... $104,000 $0
Direct labor........................... 42,900 0
Variable overhead................ 11,700 0
Purchase cost...................... 0 171,600
Total relevant costs...... $158,600 $171,600

The offer would be rejected and the company would continue to produce internally.
2. Make Buy
Direct materials.................... $104,000 $0
Direct labor........................... 42,900 0
Variable overhead................ 11,700 0
Setups................................... 3,480 0
Inspections........................... 12,300 0
Materials handling............... 2,250 0
Purchase cost...................... 0 171,600
Total relevant costs...... $176,630 $171,600

Now, it is $5,030 ($176,630 – $171,600) less expensive to buy outside.

3. In making this decision Brees should consider such qualitative factors as the quality of the
part, the reliability of the supplier, the effect of labor reductions on employee morale, the
possibility of price increases in the future, and the effect on the overall strategic position of
the firm. The strategic implications are particularly important. Does Brees really want to
reduce the level of backward integration? If Brees is pursuing a cost leadership strategy, is
purchasing the part the best way of reducing costs? Or should it first examine ways of
reducing costs internally before making a purchase decision? It may be possible to reduce
waste and inefficiency to the point where internal production is much better (from a cost
reduction point of view) than external purchase.
4. The controller does have a point. Purchasing the part will affect a number of other
activities such as purchasing, receiving, and paying bills. If these activities do not have unused
capacity that can absorb the increased demands associated with the new part, then resource
spending could increase and this should be factored into the analysis.
The controllers’ perspective on such matter, indeed makes a good point. Purchasing the track
assembly part will affect several other activities such as purchasing, receiving, and paying
bills. Hence, if these activities do not have enough unused capacity that can absorb the
additional activity demands associated with the purchase of the new part, then resource
spending might increase and this should be taken into the account in the analysis. Therefore,
it was right for the controller to ignore the additional activity demands that purchasing would
cause, as it would really not guarantee or help save any inspection costs.