Managerial Accounting: Relevant Costing - Make or Buy Decisions, Outsourcing, Qualitative Factors

? What this actually is

A make-or-buy decision, also known as outsourcing, is a choice between producing a good or service in-house (make) or purchasing it from an external supplier (buy). This decision matters because it affects a company's costs, operational efficiency, and strategic focus. The core idea is to compare the relevant costs of each option and consider qualitative factors that might influence the decision.

? The core logic (or formula)

1. Relevant Costs: Only consider costs that differ between the two options. Ignore sunk costs and common costs.
2. Opportunity Costs: Include the value of the best alternative use of resources.
3. Qualitative Factors: Consider non-financial aspects such as quality control, flexibility, and strategic focus.
4. Cost Comparison: Calculate the total relevant costs for making and buying, then compare.
5. Decision Rule: Choose the option with the lower total relevant costs, considering qualitative factors.

? Hidden rule nobody explains

In practice, qualitative factors often outweigh quantitative costs in make-or-buy decisions. Companies may choose to make a component in-house to maintain quality control or protect proprietary information, even if buying is cheaper. Always document these qualitative reasons clearly in your analysis.

? Practical example / breakdown

Let's say Company XYZ is deciding whether to make or buy a component for its product. Here are the relevant costs:

• Make:
• Direct materials: $50,000
• Direct labor: $30,000
• Variable overhead: $10,000
• Avoidable fixed overhead: $5,000

• Opportunity cost (alternative use of production capacity): $8,000

• Buy:

• Purchase price: $90,000
• Shipping costs: $5,000

Step-by-Step Calculation:
1. Calculate total relevant costs for making: - $50,000 (materials) + $30,000 (labor) + $10,000 (overhead) + $5,000 (fixed overhead) + $8,000 (opportunity cost) = $103,000
2. Calculate total relevant costs for buying: - $90,000 (purchase price) + $5,000 (shipping) = $95,000
3. Compare the costs: - Making: $103,000 - Buying: $95,000

Decision: Based on quantitative costs, Company XYZ should buy the component. However, they should also consider qualitative factors like quality control and strategic importance.

? Your move today

Goal: Practice a make-or-buy decision analysis. Step-by-Step:
1. Identify a product or component your company (or a hypothetical company) needs.
2. Gather relevant costs for making and buying this component.
3. Calculate the total relevant costs for each option.
4. Compare the costs and consider qualitative factors.
5. Document your decision and the reasons behind it.

What to save: A completed make-or-buy decision analysis with both quantitative and qualitative considerations.

? Quick reference asset

Make-or-Buy Decision Cheat Sheet

Qualitative Factors: Quality control, flexibility, strategic focus.

Common mistakes & recovery

• Common Error 1: Including sunk costs in the analysis.
• Recovery: Remember to ignore sunk costs as they do not affect future decisions.
• Common Error 2: Overlooking opportunity costs.
• Recovery: Always consider the value of the best alternative use of resources.
• Quick Check: Verify that all relevant costs are included and sunk costs are excluded.
• Exam Tip: Under time pressure, focus on identifying and comparing relevant costs first, then briefly mention qualitative factors.

? Completion check

"I can perform a make-or-buy decision analysis, comparing relevant costs and considering qualitative factors, to determine the best option for a company."