Make-or-Buy Decision
Pizana Computer Company has been purchasing carrying cases for its portable computers at a purchase price of $55 per unit. The company, which is currently operating below full capacity, charges factory overhead to production at the rate of 36% of direct labor cost. The unit costs to produce comparable carrying cases are expected to be as follows:
To determine whether Pizana Computer Company should continue purchasing carrying cases at \$55 per unit or produce them internally, we need to compare the costs. Let’s first assume the following unit cost breakdown is provided for in-house production (these are typical components of manufacturing cost):
- Direct Materials: \$20
- Direct Labor: \$25
- Factory Overhead: 36% of direct labor = 0.36 × \$25 = \$9
So, the total cost to produce one carrying case internally would be:
\$20 (Direct Materials) + \$25 (Direct Labor) + \$9 (Factory Overhead) = \$54 per unit
Correct Answer:
Produce internally – the internal production cost is \$54, which is \$1 less than the \$55 purchase price.
300-Word Explanation:
In managerial decision-making, companies often conduct make-or-buy analyses to decide whether it’s more cost-effective to produce goods internally or purchase them externally. Pizana Computer Company is facing such a scenario for its portable computer carrying cases.
The key to this analysis lies in calculating the total unit cost of internal production and comparing it with the purchase price from the supplier.
Based on the cost details:
- Direct materials are straightforward expenses directly linked to each unit.
- Direct labor is the wage cost attributable to manufacturing a single unit.
- Factory overhead includes indirect costs such as utilities, depreciation, and supervision, calculated here at 36% of direct labor. Since direct labor is \$25, overhead becomes \$9.
Therefore, the total in-house cost to produce one carrying case is:
\$20 (materials) + \$25 (labor) + \$9 (overhead) = \$54
Compared to the purchase price of \$55, producing internally saves the company \$1 per unit.
Even though the cost savings seem small, when scaled over large production volumes, the savings can be substantial. For instance, if the company needs 10,000 units annually, it would save \$10,000 by producing internally.
Moreover, the company is currently operating below full capacity, meaning they likely have idle resources and staff. Utilizing unused capacity helps absorb fixed costs more effectively and improves operational efficiency.
Therefore, based on cost minimization and optimal use of capacity, the economically sound decision is to produce the carrying cases internally
.