Question 18.3: A make or buy decision Zam Limited uses an important compone...
A make or buy decision
Zam Limited uses an important component in one of its products. An estimate of the cost of making one unit of the component internally is as follows.
| £ | |
| Direct materials | 5 |
| Direct labour | 4 |
| Variable overhead | \underline{3} |
| Total variable cost | \underline{\underline{12} } |
Additional information:
1 Fixed costs specifically associated with manufacturing the components are estimated to be £8000 per month.
2 The number of components normally required is 1000 per month.
An outside manufacturer has offered to supply the components at a cost of £18 per component.
Required:
Determine whether Zam Limited should purchase the components from the outside supplier.
Points
Assuming that the cost data given in the question are accurate, the first step in answering the question is to calculate the cost of manufacturing the components internally. Although the variable cost of each unit is given, there may be some fixed costs directly associated with manufacturing internally and these have to be taken into account.
The fixed costs cause us a problem because the monthly activity levels may vary. However, we can only work on the data given in the question, i.e. 1000 units per month.
Calculations
Total cost of manufacturing internally 1000 units per month of the component:
| £ | |
| Total variable cost (1000 units × £12) | 12 000 |
| Associated fixed costs | \underline{8 000} |
| Total cost | \underline{\underline{20 000} } |
| Total unit cost (£20 000 ÷ 1000) | \underline{\underline{£20} } |
Tutorial notes
1 Assuming that Zam Limited requires 1000 units per month, it would be cheaper to obtain them from the external supplier (£20 compared with £18 per component).
2 The above assumption is based on purchases of 1000 units. The more units required, the cheaper they would be to manufacture internally. In order to match the external price, the fixed costs can be no more than £6 per unit (the external purchase price of £18 less the internal variable cost of £12 per unit). If the fixed costs were to be limited to £6 per unit, the company would need to manufacture 1334 units (£8000 ÷ £6). The total cost would then be the same as the external cost (£24,000) but it would require a one-third increase in the activity level.
3 The cost data should be checked carefully (especially the estimated associated fixed costs) and the monthly activity level reviewed. It might then be possible to put forward a tentative recommendation.
The decision
Given the data provided in the question, it would be cheaper to purchase the components externally. This would free some resources within Zam Limited enabling it to concentrate on manufacturing its main product.
However, there are a number of other considerations that need to be taken into account. In particular the following questions would need to be asked.
- How accurate are the cost data?
- How variable is the monthly activity level?
- Is the external supplier’s component exactly suited to the company’s purposes?
- How reliable is the proposed supplier?
- Are there other suppliers who could be used in an emergency and at what cost?
- What control could be exercised over the quality of the components received?
- How firm is the quoted price of £18 per component and for what period will that price be maintained?
- How easy would it be to switch back to internal manufacturing if the supplier proved unreliable?
It follows that much more information (largely of a non-cost nature) would be required before a conclusive decision could be taken.