Chapter 3

Incremental Analysis
Lecture 8
 • A make or buy decisions is any decision by a
company to acquire goods or services internally
or externally. A restaurant that uses its own
ingredients in preparing meals “makes”, one that
serves meals from frozen entrees “buys”.
• Make versus buy refers to short-term
outsourcing. Outsourcing describes a company’s
2. Make-it or decision to purchase a product or service from an
outside supplier rather than producing it in-
house.
Buy-it • The key factor in such decisions is consider the
Decisions relevant costs, which represent the short-term
costs to make the item in-house. They are the
incremental or differential costs, which include
the variable costs to manufacture the product as
well as any avoidable fixed costs related to
manufacturing the product and any forgone
contributions caused by manufacturing the
product.
• The common fixed costs are irrelevant.
 Case 3 (On Make-or-Buy)
The current cost of developing prints in U-Develop
100,000 PER company follows:
UNITS UNIT
U-Develop has received an offer from an outside
developer to process the desired volume of prints
Direct materials $5,000 $0.05 for $0.25. The relevant range of production is from
Direct Labor 12,000 0.12 1 to 200,000 units. The $4,000 are direct fixed cost
Variable MOH 3,000 0.03 of leasing the machine to process the print, which
Fixed MOH 4,000 can be cancelled if the company eliminated the
Common costs 10,000 product.
allocated to this Will the company process this product internally
product line $34,000 or accept the offer for the outside supplier?
Total costs
At which volume level the alternative of buying
will be preferable?
 Process Alternative: Difference
prints Outsource
Status processing
Quo
*100,000 u x $0.25 = $25,000
Direct material $5,000 $25,000* $20,000 Higher
Direct labor 12,000 - 12,000 Lower The decision is to process the prints
internally because the costs will increase
VOH 3,000 - 3,000 Lower by $1,000 if the company purchases it
FOH 4,000 - 4,000 Lower from an outside supplier.
Common costs 10,000 10,000 -
Total costs $34,000 $35,000 $1,000 Higher
 • The make-or-Buy decision is sensitive to volume. If the
company reduced the volume of prints to 50,000 units, the
total cost variable costs will be reduced to the half ($5,000 +
The Make-or- $12,000 + $3,000)/2 = $10,000 and the fixed costs and
common costs will remain the same $14,000 then the total
Buy decision costs of processing the prints internally will be $24,000,
and the volume while the cost of purchasing it from the supplier will be
($0.25x50,000u) + $10,000 = $22,500.
 • To set the exact volume in which the making/buying decisions
will be preferable. Apply the following equation which
consider only the costs affected by the make-or-buy
decisions:
Make = Buy
The Make-or- Direct Fixed OH+ Variable costs= Cost to outsource processing
Buy decision $4,000 + $0.20X = $0.25X
and the volume Then X = 80,000 u
At a volume higher than 80,000 the preferred alternative is to
make, (the cost of buying is higher than the cost of making), at
a volume less than 80,000, the preferred alternative is to buy
(the cost of making is higher than the cost of buying)
Make or Buy and opportunity cost:
Back to the case 3, if the facilities used to process prints could be used
to take passport and visa photos. This new service would provide a
$2,000 differential contribution. Will your decision change regarding
processing the 100,000 prints internally?
Status Quo: Alternative: Difference
Process the Outsource
prints processing and
use the facilities
for passport and
visa services
Total cost of 100,000 $34,000 $35,000 $1,000 higher
Opportunity cost of using facilities 2,000 - 2,000 lower

Total costs including opportunity costs $36,000 $35,000 $1,000 lower

Decision: Accept the alternative