make v buy decision

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  • Avatar of abdulwahabsiddiq
    abdulwahabsiddiq
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    A factory’s entire machine capacity is used to produce essential components.The production costs of using the machines are as follow.
    $
    variable 30000
    fixed 50000
    total 80000

    if all component production was outsourced then the machine could be used to produce othe items that would generate additional contribution of 50000.Assume the fixed cost will still be incurred if production is outsourced.
    WHAT IS THE MAXIMUM PRICE THAT THE COMPANY SHOULD BE WILLING TO PAY TO THE OUTSIDE SUPPLIER FOR THE COMPONENT?

    WHY IT IS 80000$ SOME CAN EXPLAIN THIS?


    Avatar of Seah
    Seah
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    This is in line with relevant costing, variable cost of $30000 is surely a relevant cost. Then if you outsource the production (buy component from outside), the machine can be used to produce items that will earn $50000, this sentence was given to show that, if the company did not outsource and continue the production, there will be an opportunity cost of $50000 which is also relevant cost. Fixed cost will be not relevant because it will still be incurred if production is outsourced, it is a committed cost.
    Okay then you come to the point of decision-making, the maximum price that you want to pay supplier should be not more than your own relevant cost which is $30000 + $50000 = $80000. If supplier charges for less than this amount, then it is worth to buy from the supplier (outsource). Do you get it now? :)


    Avatar of abdulwahabsiddiq
    abdulwahabsiddiq
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    i didnt get that what is actually being done and why.I know relevant cost and irrelevant but cant get the logic. if there is no oppertunity cost then how much we have to pay 30000? but why. if we made in house we loose 50000 contribution so that it is relevant but if we give this to outside then we are not loosing oppertunity then it will be irrelevant for this decision? why we are giving 30000 and 50000 simply we shouldnt give more that this out of our pocket? tell me simply why it is being done .


    Avatar of Seah
    Seah
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    Okay firstly if the machine cannot do anything if company outsource, then there is no opportunity cost and therefore maximum price will be $30000.

    For your second question, you haven’t made the opportunity cost concept cleared, you need to change your way of thinking a bit, you are saying that when you buy outside you won’t lose opportunity, but think again, “[/b]if you buy outside, you can use your machine to make other items which will generate $50000″, this is your opportunity cost. Think in real life, when we are making something and we have option to buy outside, then before we buy outside we have to think “is buying outside better or make for ourself better?”. With this question in your mind, you are going to compare your relevant cost with the purchase cost outside, if our relevant cost is lower than purchase cost outside, then it is better that we continue our production, that’s why maximum price that company is willing to pay should be less than or equal to company’s relevant cost.

    For your third question, it is simple, if you give more out of your pocket, you are making more costs than before, meaning that it is better you continue your production if supplier charge higher than $80000, as simple as that.


    Avatar of abdulwahabsiddiq
    abdulwahabsiddiq
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    correct me if i am wrong. All i understand is that if we make that product we have a cost of 80,000. so we take from supplier that it should not be more than 30000. because variable is revelant and fixed is not. so if this machine can earn 50,000 so more we can pay on 30,000 is 50,000 so total 80,000 this revelant costing rule simply means company should not suffer extra cost e.g is we pay 90000 then it is the 10000 which the company will have to suffer.


    Avatar of Seah
    Seah
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    Correct, you will not want to buy outside if supplier charges more than what your costs are now, we ignore fixed cost because even when you buy from outside you are still gonna incur it.


    Avatar of abdulwahabsiddiq
    abdulwahabsiddiq
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    thanks a lot!

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