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:
To determine whether Pizana Computer Company should make or buy the carrying cases, we must compare the relevant costs of making the cases internally versus the cost of buying them externally.
Let’s start with the given details:
- Purchase cost (buy option): $55 per unit
- The company operates below full capacity, meaning it has idle resources (especially labor and overhead).
- Overhead applied at 36% of direct labor cost.
Let’s assume the following expected unit costs to make the carrying cases internally (based on standard examples):
- Direct materials: $20
- Direct labor: $25
- Factory overhead (36% of direct labor): 36% of $25 = $9
- Total manufacturing cost: $20 + $25 + $9 = $54
Step 1: Compare the costs
- Buy cost: $55 per unit
- Make cost: $54 per unit
Step 2: Analyze decision factors
Although the cost difference seems small ($1 per unit), the key factor here is that the company is operating below capacity. This means:
- The resources (labor and factory space) used to make the carrying cases are not displacing other profitable activities.
- Since overhead is applied based on direct labor, and the company is below capacity, much of this overhead may be fixed and would be incurred regardless of production. Therefore, some portion of overhead is not relevant in the short term.
If we consider only relevant costs (direct materials and direct labor), then:
- Relevant cost to make = $20 (materials) + $25 (labor) = $45
- Compare with buy cost = $55
This makes producing the cases in-house $10 cheaper per unit, when fixed overhead is excluded.
✅ Correct Decision: Make the carrying cases internally.
🧠 Explanation (300+ words):
In a make-or-buy decision, a company evaluates whether it is more cost-effective to manufacture a product in-house or purchase it from an external supplier. In this case, Pizana Computer Company is currently buying carrying cases for $55 each but has the potential to produce them in-house for $54. On the surface, the savings appear to be only $1 per unit. However, this small difference warrants deeper analysis of relevant versus irrelevant costs.
A crucial factor is that Pizana is operating below full capacity. This implies that the company has available labor and facility space that are not being used for other profitable production. In such a scenario, many of the overhead costs that are typically allocated to products are actually sunk or fixed costs in the short term. These fixed overheads will be incurred whether the company produces the cases or not, and so they should not influence the decision.
When we isolate the relevant costs—direct materials ($20) and direct labor ($25)—the in-house production cost becomes $45 per unit. This is significantly lower than the external purchase price of $55. This $10 saving per unit becomes especially impactful when multiplied across a large production volume.
Thus, from a cost perspective, and considering the opportunity to utilize idle capacity, making the cases is the more financially sound decision. Additionally, by manufacturing the cases in-house, the company may gain better control over quality, production timelines, and supply chain risks, adding strategic value beyond the cost savings.
In conclusion, since the relevant cost to make the carrying cases is lower than the cost to buy, and because the company has unused production capacity, Pizana should manufacture the cases internally.