Make or Buy Decision

Introduction
This exercise guides you through the decision making process of whether a business decides to make or buy a product used in manufacturing. After the video explains the various calculations performed to determine relevant costs, you will be asked to make a decision about what to do. The exercise will also show you how to determine a point of indifference between two alternatives.

Do you Make or Buy?

Based solely on the impact on income, should Company XYZ Make or Buy these units?

Please click on your selection for feedback:

No, this is incorrect as the cost for Company XYZ to Make these units is $40,000 higher.

Yes, Company XYZ should Buy rather than Make, since the Buy alternative is the more profitable alternative. Comparing the Buy alternative with the Make alternative there is a difference of $40,000 dollars ($1,100,000 - $1,060,000 = $40,000). Company profits would be higher by $40,000 dollars per month if they Buy the product from the outside company.

Point of Indifference

Now let’s consider the production and sales volume level at which Company XYZ is indifferent between the buy versus make alternatives.

The decision of whether or not to acquire the product can be examined based on a concept called the indifference point.

The point of indifference is the value for the variable of interest in the problem such that the company is indifferent between the two alternatives.

We set this up as a decision between alternatives, but leave the variable of interest as X, which is the number of units sold.

Calculation

To calculate the volume at which the company is indifferent between the two alternatives in this example, you would set the two alternative specific sums equal to each other using algebraic expressions, and solve for X. Refer to the exercise information provided in this table to help you in deriving the equation.

	Make	Buy
Direct Materials (DM)	-10X
Direct Labor (DL)	-4X
Variable Manufacturing Overhead (VMOH)	-2.5X
Fixed Manufacturing Overhead (FMOH)	-$275,000	-$110,000
Buy		-19x

Decision?

What is the point of indifference in production and sales volume?

Please enter your answer in the box provided:

Hint: Remember to balance the equation and solve for X, such that: -16.5X +-$275,000 = -19X+-$110,000

Hint: The equation should reduce to 2.5X = 165,000, and then solve for X.

Summary
The sales and production volume at which the company decides to either make or buy the product is 66,000 units. This is referred to as the point of indifference.

It informs the company on how many units they have to sell to be indifferent between manufacturing the product themselves and buying it from another company.

If production and sales volume exceeds this level, then the company will be better off making the units.

If the production and sales volume falls short of this level, then the company will be better off buying the units.

Unit Number Impact on Indifference

Select various values for number of units the XYZ company may expect to produce and sell and observe how this impacts the cost associated with the make or buy option.

Units (X)	Make Relevant Variable Cost (16.5X)	Make Relevant Fixed Cost	Make Net Relevant Revenue	Buy Relevant Variable Cost(19X)	Buy Relevant Fixed Cost	Buy Net Relevant Revenue