Incremental Analysis - Make or Buy - YouTube

In this video, I cover the basic incremental analysis

for the make or buy decision.

"Gibbs company purchases sales and produces sailboats.

It currently produces 1200 sailboats per year,

operating at normal capacity, Gibbs purchases sales at $250 each,

but the company is considering using the excess capacity to manufacture the sails instead."

And then the paragraph lists out all the variable costs.

So we need to do our analysis of the make or buy decision.

So even though right now they're buying them,

when we perform our analysis, we always go from make on the left to buy.

So that's the way we're going to set up our table.

So first let's find our direct materials cost.

If we look in the paragraph,

the paragraph tells us that the manufacturing cost per sail would be $100 for direct materials.

So if we take that $100 per sail, times the 1200 sails,

our total cost to make the sails for direct materials would be 120,000.

Next we can find our direct labor.

Again, if we go back to the paragraph,

the paragraph tells us that our direct labor costs are $80 per sail.

And so to find our total labor cost, we take our $80 per sail,

times the 1200 sails, to determine the total labor would be $96,000.

Now we can see on both the materials and the labor,

if we make the products, we have those costs.

If we choose to buy, we don't have to pay direct materials or direct labor,

so when we're comparing make to buy

that decreasing cost causes an increase in net income for both of those items.

Now we need to look at our overhead.

If we read the paragraph, it tells us that the cost for overhead is $100.

However, it also tells us that the overhead is based on 78,000 of annual fixed overhead.

Since the fixed overhead needs to be paid whether they make or buy,

that is not factored into our decision making process.

So what we can do, is we can take the 78,000 of fixed overhead,

divide it by the 1,200 sailboats

to determine that our fixed overhead cost per unit is $65.

And if my total overhead is 100 and the fixed is 65,

then the variable cost per unit is $35 for overhead.

Now we can take that cost, multiply it by our number of sails

to determine that if they choose to make,

the total variable overhead costs would be $42,000.

If they choose to buy, they would not have those costs

which therefore causes an increase in net income.

Now of course, if they choose to buy the sails, they have to pay for the sails.

And the paragraph tells us that the purchase price is $250 each for the sails.

And so if we take that, times the 1200 sails, our total cost to buy the sales is $300,000.

Now if we "make", that cost's a zero.

If we buy that cost increases to 300,000.

That increase in costs, causes a decrease in net income.

And so if we do the math, we can see that choosing to make the sails

would actually cause net income to increase.

Because by buying them right now, they have a $42,000 decrease in net income.

So they should choose to make the sails.

But now if we read Part B it says,

"If Gibbs suddenly finds an opportunity

to rent out the unused capacity of its factory for 77,000 per year,

would your answer to Part A change?"

And so what they're telling us there, is that there's an opportunity cost

if they choose to make the sails,

they cannot rent out the unused capacity for the 77,000 per year

So the cost of making includes this opportunity cost of 77,000.

We're adding up costs here, so it goes in our "make" column

because it's a cost that we're gonna have

because basically we're losing this opportunity.

And so now when we look at our totals, it tells us that they should choose to buy

because by buying, it causes an increase in net income of 35,000.

So that opportunity cost comes into play and changes our make or buy decision.