Make Buy Decisions - New Project 5

Quality Bikes, Inc., currently produces racing bikes. Management is interested in outsourcing production of these bikes to a reputable manufacturing company that can supply the bikes for $600 per unit. Quality Bikes incurs the following annual production costs to produce 2,000 racing bikes internally:

Outsourcing production eliminates all variable production costs, the production supervisor’s salary, and factory insurance costs. Factory building and equipment lease costs will remain the same regardless of the decision to outsource or to produce internally.

1. Perform differential analysis using the format presented in the following Table Make-or-Buy Differential Analysis. Assume making the bike internally is Alternative 1, and buying the bike from an outside manufacturer is Alternative 2.

2. Which alternative is best? Explain.

3. Summarize the result of outsourcing production using the format presented below in the Summary of Differential Analysis for Best Boards, Inc.

(1) $1,200,000 = $600 per unit × 2,000 units.

Buying the bikes from an outside supplier is the best alternative. This alternative results in total costs of $1,380,000, providing $30,000 in savings compared to the $1,410,000 cost of producing bikes internally

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.

Best Boards produces each wakeboard for $110, and Jim Muller, vice president of operations, received a bid for $70 per board from an outside manufacturer. Best Boards’ president asked the company’s accountant, Amy Eckstrom, to investigate whether it makes sense for Best Boards to hire an outside company to produce the wakeboards. What information should Amy provide that will help management make this decision?

Since Best Boards produces 10,000 wakeboards each year, the product cost per unit is

• All variable production costs will be eliminated if Best Boards buys the wakeboards rather than making them. These are differential costs.

• The factory equipment lease will continue for several years whether Best Boards makes or buys the wakeboards. This is not a differential cost.

• The factory building lease covers several years, so this cost will continue whether Best Boards makes or buys the wakeboards. This is not a differential cost.

• One of Best Boards’ two production supervisors was hired recently, is paid $50,000 per year, and can be let go if needed. This is a differential cost.

• The other of Best Boards’ two production supervisors has been with the company for several years, is paid $90,000 per year, and has five years remaining on her contract. This is not a differential cost.

That we'll save $90,000 by making the wakeboards internally.

Question: The Differential Amount column presented above Make-or-Buy Differential Analysis for Best Boards, Inc. indicates Best Boards would be better off producing wakeboards internally. However, management may want a more concise explanation of why production costs are $90,000 higher when outsourcing production. How can we present this information in a more concise format?

Answer: We show a more concise presentation in the Summary of Differential Analysis for Best Boards, Inc., which includes the Differential Amount column shown in our Make-or-Buy Differential Analysis along with a brief description for each item.

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.

The analysis shown in our Summary of Differential Analysis for Best Boards, Inc. is particularly useful if all costs are not easily identified, and differential costs can be determined. After all, the goal of differential analysis is to analyze the costs that differ from one alternative to the next. We often use the term avoidable costs to describe a cost that can be avoided, or eliminated, if one alternative is chosen over another. If Best Boards chooses to buy the product from an outside producer, the company avoids such costs as direct materials, direct labor, manufacturing overhead, and the salary of one supervisor. In this context, avoidable cost is the same as differential cost.