Introduction

Our approach is to carry-out make or buy differential analysis, which we need to outline the needed
cost or revenue details depending on the financial data we want to use as we could use production
cost element or contribution margin to determine profit and either of this two financial information
approach both approach would give us same decision. However, we are using cost analysis.
Note:
• All the values on the below calculation are in dollar currency $
• 50,000 unit is annually based. Therefore, all figures on monthly bases shall be converted
yearly.
1.1 Product costs associated with vacuum production of engines:
Cost at Revenue
50,000unit Analysis at
50,000unit

Sales Revenue @150 7,500,000

Variable cost:
Direct material 75000*12 900,000
Direct labor 100,000*12 1,200,000
Variable factory O/H 7.50*50,000 375,000
(2,475,000)

Contribution Margin 5,025,000.

Fixed Cost:
Fixed factory overhead 36*50,000 1,800,000 (1,800,000)
(See workings 1)
Product cost/ profit 4,275,000 3,225,000

Since vacuum produces 50,000 unit each year, the product cost per unit is $95 (= $4,750,000 ÷
50,000 units). However, we must identify which of the costs listed previously are differential costs
if the company let the third party make the engine. That is, we must determine which costs will
change/ relevant and which will remain the same. Here’s what we found:
1. All variable production costs will be eliminated if third party makes the engines rather than
making them internally. These are differential costs, that is, relevant.
2. The fixed factory cost is a will continue for several years whether vacuum makes or third
party make the engine. This is not a differential cost.
3. There would be changes in fixed cost allocated to the making of engine by the third party
such as $1,350,000 per year, and can be let go if needed. This is a differential cost. 75%
of fixed factory overhead, which represents executive salaries, rent, depreciation, and
 taxes, continue regardless of the decision has been with the company for several years,
amount to $1,350,000 per year, and has many years remaining. This is not a differential
cost.

Using differential analysis to determine which alternative is best for the company. Our analysis
appears in Figure 1.2 “Make-or-Buy Differential Analysis for vacuum.". Because the focus of
make-or-buy decisions is on product costs, and because sales revenue is not differential to this
decision, it is not necessary to include sales revenue in the analysis. This in turn eliminates the
need to show the contribution margin or net income. (Even if sales revenue were included, the
outcome would remain the same.)
Table 1.2
Alternative 1 Alternative 2. Differential Alternative
Outsourcing @ amount
50,000

Sales Revenue
Cost externally@60 3,000,000 (3,000,000) Lower
Direct Material 900,000 0 900,000 Higher
Direct labour 1,200,000 0 1,200,000 Higher
Variable F/OH 375,000 0 375,000 Higher
Fixed factory O/H 1,800,000 1,350,000 450,000 Higher
See workings 1
4,275,000 4,350,000 (75,000) Lower

Note
a. $3,000,000 = $60 per unit × 50,000 units.
b. 75% of fixed factory overhead, which represents executive salaries, rent, depreciation, and
taxes, continue regardless of the decision must be paid $1,350,000 per year even if the
company make or outsource the product. The other cost, which amount to $75,000 per year,
can be let go if the company uses third party.

c. As you compare these two figures, notice that only differential costs are presented in table
1.3 "Summary of Differential Analysis for Vacuum.", and therefore costs for the fixed

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 factory overhead are excluded from 1.3 "Summary of Differential Analysis for vacuum.".
That is, costs that do not differ from one alternative to another are excluded from the
summary differential analysis since this information is irrelevant to the decision. The
amounts in parentheses in 1.3 "Summary of Differential Analysis for vacuum." indicate a
negative impact on profit, and amounts without parentheses indicate a positive impact on
profit.

d. Workings 1.
Direct Labour cost per unit = 1,200,000/50,000
=24
Fixed variable oveahead = 150% of 24
150/100 * 24= 36
36*50,000=1,350,000.00
Table 1.3
SUMMARY OF DIFFERENTIAL ANALYSIS

Result from outsourcing third party to make the engine

Cost increases from third part making (3,000,000)

Direct Material cost savings 900,000
Direct labour cost savings 1,200,000
Variable F/OH cost savings 375,000
Other cost if company outsources 450,000
Cost increases from outsourcing (75,000)
Amounts shown in parentheses indicate a negative impact on profit, and amounts without
parentheses indicate a positive impact on profit. (Heisinger, K., & Hoyle, J. B. (n.d))
We often use the term avoidable cost to describe a cost that can be avoided, or eliminated, if one
alternative is chosen over another. If vacuum chooses to buy the product from an third party
producer, the company avoids such costs as direct materials, direct labor, manufacturing overhead,
and other factory cost. In this context, avoidable cost is the same as differential cost. (Heisinger,
K., & Hoyle, J. B. (n.d))

Conclusion and recommendation

Making the engines internally is the best alternative. This alternative results in total costs of
$4,275,000, providing $75,000 in savings compared to the $1,410,000 cost of producing engine
externally.

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Reference list

Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for

Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html

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