© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Incremental Analysis Lecture 18

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Should I continue to make the part, or should I buy it? I suppose I should compare the outside purchase price with the additional costs to manufacture the part. What will I do with my idle facilities if I buy the part? Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Incremental costs also are important in the decision to make a product or buy it from a supplier. The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead. We should not use the predetermined overhead rate to determine product cost. Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Exitel makes computer chips used in one of its products. Unit costs, based on production of 20,000 chips per year, are: Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased. Exitel has no alternative use for the facilities. Should Exitel accept the offer? Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Make or Buy Decisions Differential costs of making (costs avoided if bought from outside supplier) Exitel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Fixed costs are irrelevant to decision.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin If Exitel buys the chips from the outside supplier, the idle facilities could be leased to another company for $250,000 per year. Should Exitel buy the chips and lease the facilities? Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Make or Buy Decisions The real question to answer is, “What is the best use of Exitel’s facilities?” The opportunity cost of facilities changes the decision.

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. As long as rebuild costs are recovered through sale of the product, and rebuilding does not interfere with normal production, we should rebuild. Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin OserCo has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or rebuilt at an additional cost of $.80 per unit. If rebuilt, the units can be sold for the normal selling price of $1.50 each. Rebuilding the 10,000 defective units will prevent the production of 10,000 new units that would also sell for $1.50. Should OserCo scrap or rebuild? Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 10,000 units × $1.50 per unit 10,000 units × $0.40 per unit Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin 10,000 units × $0.80 per unit 10,000 units × ($ $1.00) per unit Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin OserCo should scrap the units now. If OserCo fails to include the opportunity cost, the rework option would show a return of $7,000, mistakenly making rebuild appear more favorable. Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Product 2 Joint Costs Product 1 Product 3 Two or more products produced from a common input are called joint products. The split-off point is the point in a process where joint products can be recognized as separate products. Joint costs are the costs of processing prior to the split-off point. Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Businesses are often faced with the decision to sell partially completed products at the split-off point or to process them to completion. General rule: process further only if incremental revenues > incremental costs. Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Ames Co. produces two products, A and B, from this process. Should the products be sold at split-off or processed further? Common Production Process Final Sale $120,000 Split-Off Point Joint Cost $100,000 Revenue $70,000 Additional Processing $40,000 A B Additional Processing $20,000 Final Sale $65,000 Revenue $50,000 Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Decision: Process product A, but sell product B at the split-off point. Note that the $100,000 joint cost is irrelevant to the processing decision. Product A incremental revenue = $120,000 - $70,000 Product B incremental revenue = $65,000 - $50,000 Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Joint costs are really common costs incurred to simultaneously produce a variety of end products. Joint costs are commonly allocated to end products on the basis of the relative sales value of each product or on some other basis. Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Joint costs are not relevant in decisions regarding what to do with a product after the split-off point. As a general rule... It is always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs. Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin Hey dude, it’s party time! Source: Adopted from McGraw-Hill/Irvin