Accounting: The Language of Business - Vol. 1 (Part 149)

There is no accounting for human beings.

Mark Twain

Differential Analysis and Product Pricing (Part C)

by

Charles Lamson 

Make or Buy

The assembly of many parts is often a major element in manufacturing some products, such as automobiles. These parts may be made by the product's manufacturer, or they may be purchased. For example, some of the parts for an automobile, such as the motor, may be produced by the automobile manufacturer. Other parts, such as tires, may be purchased from other manufacturers. In addition, in manufacturing motors, such items as spark plugs and nuts and tools may be acquired from suppliers.

Management uses differential cost [the difference between the cost of two alternative decisions (corporatefinanceinstitute.com)] to decide whether to make or buy a part. For example, if a part is purchased, management has concluded that it is less costly to buy the part than to manufacture it. Make or buy options often arise when a manufacturer has excess productive capacity in the form of unused equipment, space, and labor.

The differential analysis is similar whether management is considering making a part that is currently being purchased or purchasing a part that is currently being made. To illustrate, assume that an automobile manufacturer has been purchasing instrument panels for $240 a unit. The factory is currently operating at 80% of capacity, and no major increase in production is expected in the near future. The cost per unit of manufacturing an instrument panel internally, including fixed costs, is estimated as follows:

If the make price of $280 is simply compared with the price of $240, the decision is to buy the instrument panel. However, if unused capacity could be used in manufacturing the part, there would be no increase in the total amount of fixed factory overhead costs [Fixed overheads are costs that remain constant every month and do not change with changes in business activity levels. Examples of fixed overheads include salaries, rent, property taxes, depreciation of assets, and government licenses (corporatefinanceinstitute.com).]. Thus, only the variable factory overhead costs [costs that change as the volume of production changes or the number of services provided changes (investopedia.com)] need to be considered. The relevant costs are summarized in the differential report in Exhibit 6.

EXHIBIT 6 Differential Analysis Report---Make or Buy

Other possible effects of a decision to manufacture the instrument panel should also be considered. For example, capacity committed to the instrument panel may not be available for more production opportunities in the future. This decision may affect employees. It may also affect future business relations with the instrument panel supplier, who may provide other essential parts. The company's decision to manufacture instrument panels might jeopardize the timely delivery of these other parts. 

Replace Equipment

The usefulness of fixed assets may be reduced long before they are considered to be worn out. For example, equipment may no longer be efficient for the purpose for which it is used. On the other hand, the equipment may not have reached the point of complete inadequacy. Decisions to replace usable fixed assets should be based on relevant costs. The relevant costs are the future costs of continuing to use the equipment versus replacement. The book values of the fixed assets being replaced are sunk costs [A sunk cost, sometimes called a retrospective cost, refers to an investment already incurred that can't be recovered. Examples of sunk costs in business include marketing, research, new software installation or equipment, salaries and benefits, or facilities expenses (productplan.com)] and are irrelevant.

To illustrate, assume that a business is considering the disposal of several identical machines having a total book value of $100,000 and an estimated remaining life of 5 years. The old machines can be sold for $25,000. They can be replaced by a single high-speed machine at a cost of $250,000. The new machine that has an estimated useful life of 5 years and no residual value [the estimated value of a fixed asset at the end of its lease term or useful life (investopedia.com)]. Analyses indicate an estimated annual reduction in variable manufacturing costs from $225,000 with the old machine to $150,000 with the new machine. No other changes in the manufacturing costs or the operating expenses are expected. The relevant costs are summarized in the differential report in Exhibit 7.

EXHIBIT 7 Differential Analysis Report---Replace Equipment

Other factors are often important in equipment replacement decisions. For example, differences between the remaining useful life of the old equipment and the estimated life of the new equipment could exist. In addition, the new equipment might improve the overall quality of the product, resulting in an increase in sales volume. Additional factors could include the time value of money and other uses for the cash needed to purchase the new equipment.

The amount of income that is forgone from an alternative use of an asset, such as cash, is called an opportunity cost. For example, your opportunity cost of attending school is the income forgone from lost work hours. Although the opportunity cost does not appear as a part of historical accounting data, it is useful in analyzing alternative courses of action. To illustrate, assume that the cash outlay of $250,000 for the new equipment, less the $25,000 proceeds from the sale of the present equipment, could be invested to yield a 10% return. Thus, the annual opportunity cost related to the purchase of the new equipment is $22,500 (10% * $225,000). 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 997-999*

end