Make or Buy Decision - Decision Making, Cost Management Video Lecture -

in this video we're going to talk about
the maker by decision which basically
revolves around a firm trying to decide
whether it should manufacture a product
internally or purchase it from an
outside supplier so let's say that we
have a company called speedy bicycles
and they manufacture bicycles and sell
them now they're trying to decide
whether or not they should make the bike
saddle which is the seat on the bicycle
so that's a bike seat they're trying to
decide should they manufacture the seat
itself right they make an entire bicycle
but they could just buy that seat from
an outside supplier right so let's say
that there isn't a supplier that says
you know what will sell you bike seats
for it for ten dollars a piece so that
for five thousand saddles for five
thousand seats it would be fifty
thousand dollars to just buy the bike
saddles that they need to do their
manufacturing so now they're trying to
decide okay we're going to make the rest
of the bicycle right but we could just
buy this seat portion and then just put
it on our bicycle so how do we decide
whether we make or buy this saddle so we
look at it like this so we know that the
cost to get the five thousand saddles
that they need each year is fifty
thousand dollars from that outside
supplier right so now we have to say
well what is the cost of making it
internally what is the cost of
manufacturing this bike seat so let's
say that they go to the accountants and
they say hey look what's the cost of
this the accountants give them a form
like this and they say okay here are all
the cost you've got some direct
materials you've got some direct labour
involved in making these bike seats and
then you've got some variable overhead
as you produce an additional seat
there's some overhead attached with that
right that's directly related to the
saddles but then we've got some some
general overhead that just has to do
with the factory in general right so
that's stuff like overhead that has to
do with keeping the lights on in the
factory that is going to exist whether
or not we continue to manufacture the
bike saddles because we also make other
products too right we make the
handlebars for the bicycle etc etc so
we've got this general overhead and then
we also have some depreciation that's
related to a mission
gene that is specifically used to use to
make the bike saddle and that if we
don't make bike saddles anymore then we
would just junk this machine so now we
can look at these costs and if you if
you add them up you'll see that the
total cost comes out to $70,000 so
somebody might naively say well hey look
it's $70,000 to manufacture these
saddles and it's 50,000 if we just buy
them from an outside supplier so why
don't we just buy from the outside
supplier we're save ourselves twenty
thousand dollars well you have to look
at which of these costs are relevant
right and we had another video where we
talked about relevant costs and
basically relevant costs are costs that
are going to differ based on which
alternative you choose right so if we
choose for example to buy from the
outside supplier we're going to avoid
the direct material cost the direct
labor costs the the variable overhead
we're going to avoid all those costs but
the allocation of this general overhead
right like I said that might have to do
just keeping the lights on in the
factory we don't save $20,000 if we get
rid if we decide that we're not going to
you know manufacture saddles anymore we
stuff to keep the lights on the factory
for the other things that we do
manufacture so this general overhead
unless we actually have reason to
believe that some of that 20,000 and
cost would disappear if we stopped
manufacturing saddles unless we have
reasonably that we don't focus on this
at all we just ignore that right and now
with the depreciation of this saddle
machine since this machine is used
specifically to make a saddle then we
just have say hey look this is a sunk
cost right this depreciation is a sunk
cost that has to do with the past
purchase right now if we think that hey
if we may we could use this machine to
manufacture something else if it's not
being used in manufacture saddles then
okay that value right that opportunity
cost with that but that would be
relevant but we're just assuming here
that this machine can only be used to
make saddles and so if we if we stop
manufacturing saddles this machine is
worthless to us and we're going to say
that has no salvage value now if we
could sell it
for a couple hundred dollars then of
course that would that would be relevant
as well but we're going to assume in
this there's just no salvage Val
basically so that this cost is sunk this
depreciation cost is sunk and so since
we have no salvage value or alternative
use for this machine basically this this
we can just ignore this as a sunk cost
okay so now we say okay really what is
relevant here that the in terms of
continuing to make or or not make this
what we really want to focus on is not
seventy thousand we want to say forty
six thousand right because the cost we
would be avoiding which are the relevant
cost right the cost that we would be
avoiding if we decide to purchase from
the outside supplier our bicycle saddles
we would be avoiding forty six thousand
dollars which is this right here the
variable overhead the direct materials
the direct labor that all is the forty
six thousand we would avoid that in
order in order to buy from the outside
supplier so if you see it that way it's
actually cheaper right it's forty six
thousand to manufacture versus the fifty
thousand to buy from an outside supplier
so in this case it actually be a better
deal for us as a firm to continue
manufacturing these five thousand
saddles in-house instead of buying them
from the outside supplier