MAVery good question of "make or buy decision".

Answer:-
The make or buy decision will be taken based on the lower of

Relevant cost of making the product
Or
Relevant cost of buying the product

Let’s calculate the relevant cost of making and buying the product

Method 1:

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Per unit

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Total
Relevant cost of buying

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$27

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(27 X 5000)

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$135000
Saving in relevant cost

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($8)

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($ 40000) ($40000/500=$8)
Saving in Fixed cost

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($3)

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(5000 X 3)

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($ 15000)
______________________________________________________________
Relevant cost of Buying

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$16

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$ 80000……………(i)
______________________________________________________________

Relevant cost of Making
Direct Material

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$ 2

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(5000 X 2)

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$10000
Direct labour

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$12

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(5000 X 12)

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$60000
Variable overhead

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$ 5

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(5000 X 5)

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$25000
_______________________________________________________________
Relevant cost of making

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$19

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$95000……………(ii)
_______________________________________________________________
So saving on buying

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$3

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$ 15000 ….….(ii less i)
===============================================================

***You can treat the saving of relevant cost (40000/5000=8) and saving on attributable fixed cost $3 as a reduction on your buying cost. Because if you buy the product you will be able to save this cost thus you will be able recover some portion of buying cost by saving some relevant cost.

Method 2:-
You can also treat the saving of relevant cost $8 and saving of fixed cost $3 as a relevant cost of making. Because if you make the product you will not be able to save this cost using the facilities in another product. Thus increase in relevant cost of making.

Relevant cost of Making --Per unit

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Total
Direct Material

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$2

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(5000 X 2

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$10000
Direct labour

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$12

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(5000 X 12)

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$60000
Variable overhead

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$5

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(5000 X 5)

---

$25000
Saving in relevant cost

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$8

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$40000-($40000/500=$8)
Saving in Fixed cost

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$3

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(5000 X 3)

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$15000
_______________________________________________________________
Relevant cost of making --$30

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$150000…........(i)
_______________________________________________________________
Relevent cost of buying---$27

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(27 X 50000)

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$135000…..(ii)
_______________________________________________________________
Saving by buying

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$3

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$15000…..(i less ii)
===============================================================

*** In method 2, question stated that the fixed factory overhead is $7. But fixed cost is not a relevant cost unless it’s directly attributable to the product. If you look at the beginning of the question, it has been told that if the company buy the product company will be able to eliminate $3 of fixed factory overhead. This is the indicator of the fixed cost which is directly attributable the product. Thus $3 of this $7 is relevant other ($7 less $3) =$4 is not relevant.

wow! very good!...I have to spend sometime on relevant costing..have not gotten there yet right know having challenges with variances

@yvettepbabb variances analysis are not difficult at all, most of the time is standard compare with actual except the case of fixed overhead only

my problem more so capacity what am I looking for in the question? expenditure etc..