Managerial Accounting 7.2: Make or Buy Decisions - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes how to use  differential analysis to determine whether to  

make or to buy a product. That is we are a company  that manufactures a product and we are trying to  

figure out do we manufacture that internally, this is the first bullet point, or do we go to  

the outside and buy the product. And by the way  when we say go to the outside to buy a product,  

that is often called outsourcing. That is the  common term. Differential analysis can be used  

to analyze make-or-buy decisions, and we are going  to talk about how to do that in this video.   

So how is differential analysis used for make-or-buy decisions. First of all, we have to figure  

out the costs that are associated with making the  product internally, doing it on our own basically,  

and we are going to call that alternative 1. And  we also have to look at the costs associated with  

buying the product from another source, that  is outsourcing the product. And then as you'll  

see this in a second bullet point here, we have  to figure out the differential amounts between  

each of those two alternatives. And from there  the third bullet point here, we want to choose  

the alternative that has the lowest cost. Now there  are other factors to consider aside from just the  

dollar amounts and that's a separate lecture that  I've posted having to do with qualitative factors  

to consider. But here we are going to take a look  at the format that is typically used to make this  

type of a decision with the dollar amounts that  are associated with it. Here is the typical format  

that's used for a make-or-buy differential analysis.  And the company that I'm using here is called  

Best Boards Inc., and they make wakeboards. These  are the boards that people will ride on and be  

towed by boats. So they are called wakeboards and  the company is called Best Boards Inc.. The decision  

that is facing us, as Best Boards Inc., is whether  to make our wakeboards internally, and you are  

going to see the cost associated with that in this  first column, or to outsource the production of our  

wakeboards. And you will see that alternative in  the second column. And then of course we'll look  

at the difference between those two alternatives and determine our best approach, from a company, the  

company's perspective. So in the first alternative  if you'll notice these are all costs, because we're  

just looking at the costs associated with either  making the product or outsourcing the product. 

So everything you see here relates to the costs for  each of these alternatives. And you will notice that  

if we make the the wakeboards internally, the  variable cost that we are going to incur will  

be of course for direct materials, direct labor,  and manufacturing overhead. And the fixed cost  

that we expect to incur, are related to the lease  on our factory equipment that is any monthly  

amounts that we have to pay for the equipment, the  lease for the building, and the rent that we have  

to pay on the building, and our production  supervisors salaries. So those fixed costs  

are spelled out here, And therefore you'll  notice our total costs if we make our wakeboards  

internally, will be $1,100,000. Then we go to the  outside and talk to an outside supplier or maybe  

it's multiple outside suppliers and find out what  the cost would be if they made the wakeboards for  

us. And what you will see here in the second column,  is all of our costs related to direct materials,  

direct labor, and variable manufacturing overhead,  go away if we outsource production. But of course  

we are going to have variable costs going  to somebody on the outside. They are going  

to charge us a certain amount per wakeboard,  that'll be our variable cost. We also are going  

to continue to have the factory equipment lease,  and that implies that it is not easy to get out  

of that lease now, in the short term anyway, and  we also are going to have, if we outsource, will  

continue to have rent that we have to pay on the  factory building. And other in other words we're  

not going to be able to get out of that lease  quickly either. It looks like I did not give you  

the details here to support this number so I'll  just clarify it here. It looks like though that  

we'll be able to reduce our supervisor salaries  by $50,000 if we do outsource. And therefore our  

total costs will be $1,190,000. If we outsource  this production. If you look at the differential  

column then, you'll see, and we can start with a  total that it's going to cost $90,000 more if we  

choose to outsource. The reason that it is a negative  number is if you, the $90,000, is it is really  

looking at the making these products internally  versus outsourcing these products. And it will  

be $90,000 less to make these products internally.  As a result, our preferred course of action is to  

continue, assuming we're already doing this, is to  continue to produce these wakeboards internally in  

our own facility. The next slide is going to show  a summary version of this analysis. So take note  

of all the information that you see here in this  column, this differential column, that information  

is going to be summarized in the next slide. So you  can go back and forth between the two if you want  

to see where that information comes from. Some  managers prefer not to see all the detail that  

you saw in the previous slide. Instead they perhaps  just want to see a summary of the differences from  

either producing these products internally, our  wakeboards, or having somebody else do it for us,  

outsourcing that production. So that is what you  see here in this analysis. This is just simply  

summarizing the difference between producing our  wakeboards internally and outsourcing production. 

That is what we are summarizing here. So again  go back to the previous slide and you'll see  

where these numbers, right here, come from. And so to  give you an idea of what we have here, we're simply  

looking at what will happen if we outsource.  Well we know that the costs will increase if  

we buy from the outside, but we will have some  savings in direct materials, direct labor,  

and manufacturing overhead, for variable manufacturing  overhead, if we outsource. And we will also have some  

cost savings associated with supervisor salaries.  However when you net all of this out, it turns out  

that we will have a cost increase if we choose  to outsource. And that is why the decision was to  

go ahead and continue to produce internally. And  one last piece of clarification here, when you  

see a number in parentheses, that implies that  the result of that line item is a reduction in profit.

And when you see numbers that are positive,  that implies that those line items actually  

result in an increase in profit. So the bottom  line here, the fact that that's negative, means  

that if we outsource, our profit will go down  by $90,000. So here are some  

key points associated with differential analysis.  First of all, first bullet point here,

differential analysis requires that we  identify all revenues and costs that differ from  

one alternative to another, from one course of  action to another. In the previous example, we  

were only looking at costs. But if it were a  different type of an example where revenues  

were involved, for example we're thinking about  getting rid of a product line or perhaps getting,  

a dropping an unprofitable customer, then both  revenues and costs would be affected. We have  

to identify both, the differential revenues and  differential costs. Managers, second point here,  

managers typically select the alternative that  has the highest profit. And again if we are only  

looking at a differential analysis related to a  make-or-buy scenario, where we are focusing on costs,  

then the decision maker is typically going to  select the alternative that has the lowest cost.