CHAPTER 10 Cost–volume–profit analysis 439ILLUSTRATIVE EXAMPLE 10.5
Make or buy decision — outsourcing a component part
Palamara Industries produces mobile phones specifically for hearing-impaired people. One of the com-
ponents is a special flashing light that alerts the user to a call. The unit cost of making this light is as
follows:Variable costs per unit
Direct material
Direct labour
Indirect$ 0.80
0.20
0.10
Total variable costs $ 1.10
Total fixed costs
Various $60^000Fleet Ltd has offered to supply 100 000 units of the light for $1.40. If the offer is accepted, $10 000 of
the fixed costs can be eliminated. Wong Industrial has offered to lease the factory space currently used
to produce the flashing light from Palamara Industries for $560 per week.
The decision for Palamara Industries is whether to outsource production of the special flashing light
component to Fleet Ltd and lease the factory space to Wong Industrial, or continue to manufacture the
light in-house. Of the fixed costs, $50 000 is irrelevant to the decision as it is a cost that will be incurred
regardless of the decision made by Palamara Industries. For example, the $50 000 would represent allo-
cated costs such as factory rent, equipment depreciation and maintenance. If the $50 000 was included
in the analysis it would need to be assigned to both the make and buy option. The income from leasing
the factory will be an opportunity cost if the flashing light is not outsourced, so it is relevant to this
decision and reduces the cost of outsourcing the component part.Identification of relevant costsCost to make
Variable manufacturing costs ($1.10 × 100 000 units)
Avoidable fixed costs
Total relevant costs to make$$110 000
10 000
120 000
Cost to outsource
Purchase price ($1.40 × 100 000 units)
Less: Lease income ($560 per week × 52 weeks)
Total relevant costs to outsource $140 000
(29 120
110 880)The financial analysis indicates that outsourcing will benefit Palamara by decreasing costs by $9120
($120 000 − $110 880) and thereby increasing profits by $9120. Other factors to consider would be
whether Fleet Ltd:
• can deliver the lights when required
• manufacture to the same quality as that of Palamara Industries
• guarantee supply when required
• be financially stable enough to enable ongoing supply.
Focusing on full costs, the financial analysis would be as follows (you will notice that the $50 000
unavoidable costs is also now included in the outsource option):Cost to make
Variable manufacturing costs ($1.10 × 100 000 units)
Fixed costs
Total costs to make$$110 000
60 000
170 000