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:
The Correct Answer and Explanation is:
.
Unit Costs to Produce Carrying Cases Internally:
| Cost Component | Amount (per unit) |
|---|---|
| Direct Materials | $24 |
| Direct Labor | $20 |
| Factory Overhead (36% of Direct Labor) | $7.20 |
| Total Cost to Make | $51.20 |
| Cost to Buy | $55.00 |
Correct Answer:
Pizana Computer Company should make the carrying cases internally, as the cost to make ($51.20) is less than the cost to buy ($55.00) by $3.80 per unit.
Explanation:
A make-or-buy decision evaluates whether a company should manufacture a product internally or purchase it from an external supplier. The key to making this decision lies in comparing relevant costs—specifically, avoidable costs associated with making the product versus the purchase cost.
In this case, Pizana Computer Company is currently buying carrying cases for $55 per unit. However, because the company is not operating at full capacity, it has unused production resources that could be utilized to make the cases in-house.
The cost analysis reveals the internal production costs as follows:
- Direct Materials: $24
- Direct Labor: $20
- Factory Overhead (36% of Direct Labor): $7.20
Total internal cost = $24 + $20 + $7.20 = $51.20 per unit
Since this is $3.80 less than the purchase price, making the cases is the more cost-effective option. Moreover, using idle capacity avoids additional fixed costs and better utilizes existing resources, improving operational efficiency.
Importantly, this decision assumes product quality is consistent whether made or bought, and that internal production won’t displace more profitable activities. Additionally, the overhead applied (36% of direct labor) is considered relevant only if it’s avoidable; however, since the company is under capacity, the overhead cost in this scenario reflects actual incremental cost rather than sunk or allocated cost.
In summary, given the cost savings and available capacity, Pizana should opt to make the carrying cases internally, enhancing cost efficiency and leveraging underused resources.
