MA50 - Make or Buy Decision - Sample Problem

The video introduces problem 12-1a, a make or buy decision, using the relatable analogy of a restaurant deciding whether to make cheesecake in-house or buy it from a supplier. It emphasizes that this dilemma applies to many businesses and that the decision should be based on 'relevant costs,' which are not sunk and differ between the options.

Carol's Cupcakes, a business that makes all its ingredients from scratch, is approached by an icing supplier. The supplier offers icing at $3 per liter, which Carol believes is equal in quality to her own. Her current cost to produce icing is $4.50 per liter. Initially, Carol sees a clear saving of $1.50 per liter, totaling over $7,500 per year, and is inclined to accept the offer.

The presenter breaks down the costs associated with making versus buying. The 'buy' option costs $3 per liter. For the 'make' option, relevant costs include direct material ($1.00), direct labor ($0.50), and variable overhead ($0.25). Fixed overhead is scrutinized: 40 cents related to cleaning and maintenance is relevant because it would be avoided if buying, but the remaining 60 cents for depreciation of equipment with no resale value is a sunk cost and not relevant. Allocated fixed overhead is also deemed not relevant, as it is a cost that would remain regardless of the decision (e.g., rent).

After identifying only the relevant costs, the make option costs $2.15 per liter, while the buy option costs $3.00 per liter. This means Carol saves $0.85 per liter by continuing to make the icing. For 5,000 liters, the financial disadvantage of accepting the supplier's offer (i.e., buying) is $4,250 per year.

The problem then introduces a new scenario: if Carol accepts the offer, the space previously used for icing production could be used for a new bacon cupcake line, generating $5,000 in additional margins per year. Factoring this opportunity cost, the initial $4,250 disadvantage of buying is offset by the $5,000 gain from the new product line, resulting in a net advantage of $750 to buy the icing.