In a way to navigate the strong decision, we used the method of the
so called differential analysis. There exists some terms in the differential
analysis calculation for decision to buy or make new engines including sales revenue, variable cost,
contribution margin, direct fixed cost, allocated fixed cost, and profits (Saylor,
n.d). The choice of the best alternative will be based on keeping to make own
engines or buying from other companies with such costs and revenues giving the
highest profit. In reality, suppose we have an information of a vacuum
manufacturer preparing for the following cost data to manufacture one of
components of the vacuum engines:
1.
Sales revenue
-
Annual production units (revenues
in unit of sales) : 50000
-
Sell price per unit : $150
-
Total annual sale revenues : Annual
production unit * sell price per unit =$150 / unit * 50000 units = $7,500,000
2.
Variable
cost (CFO, n.d.)
-
Monthly
direct materials : $75,000
-
Annual
direct materials : $75,000 *
12 = $900,000
-
Monthly
direct labor : $100,000
-
Annual direct labor :
$100,000
*12 = $1,200,000
-
Annual variable factory overhead : $7.5 / unit * 50000 units = $375,000
-
Total annual variable cost : $2,475,000
3.
Contribution
margin : Sales
revenue – variable cost
: $7,500,000
- $2,475,000
: $5,025,000
for 50000 units
$5,025,000/50000 units = $100.50 /unit
(Making)
:
$7,500,000 for 50000 units
$7,500,000/50000 units= $150 /unit (Buying)
4.
Direct
fixed cost
-
Annual
direct labor cost/ annual production unit = $1,200,000
/50000 units = $24 / unit)
-
Fixed
factory overhead :
150 % * Direct labor cost /unit = 1.5 * $24 / unit = $36 / unit
-
Annual
fixed factory overhead (Cost of making) = $36 / unit * 50000 units =
$1,800,000.0
- Annual third party offering cost (Cost of buying) = $60 / unit * 50000 units = $3,000,000.0
5.
Allocated
fixed cost
-
75 %
of the fixed factory overhead representing depreciation, rent, salaries of
executives and taxes does not change with respect to any made decision
-
Total
annually allocated fixed cost : 75 % * $1,800,000.0
: $1,350,000.00
Further decision can be continued by using the following analytical
table,
Based on table 1, we can determined relevant and and not
relevant financial information for our differential analysis based on the
same or different values they have in the available two alternatives (Chauvin,
2014). The same values considered irrelevant or not differentiable for our
differential analysis are sales revenue having the same value of $7,500,000, and allocated fixed costs having the same value of $1,350,000.00, while the different values considered relevant or differentiable
for our differential analysis are total variable costs, contribution margin,
direct fixed cost, and profits. The incremental values of the different ones
can be clearly seen in table 1.
Based on the results in table 2 showing the summary of the results
for making new engines, we can conclude that the vacuum manufacturer should
buy new engines rather than making the new ones due to fact that besides
the variable cost of making is higher and although direct fixed cost of making
is less than those of buying, the profit of buying the new engines is
greater than that of making new ones and we lose ($1,275,000)
if we choose to make new ones.
References
Saylor. (n.d.). Customer Decisions. Customer
decisions. Retrieved September 28, 2021, from https://saylordotorg.github.io/text_managerial-accounting/s11-04-customer-decisions.html.
CFO. (n.d.). Variable cost definition:
Variable costs and decision-making. The Strategic CFO iCal. Retrieved
September 29, 2021, from https://strategiccfo.com/variable-cost/.
Chauvin, C. L. (2014). Chapter 10: Differential Analysis
(or Relevant Costs). Lumen Managerial Accounting. Retrieved September 30,
2021, from https://courses.lumenlearning.com/sac-managacct/chapter/criteria-used-in-managerial-decision-making/.
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