7.7. Business Case

Thermal’s T6 Container by Thermal Mugs, Inc

Thermal Mugs, Inc., manufactures various types of leak-proof personal drink carriers. Thermal’s T6 container, its most insulated carrier, maintains the temperature of the liquid inside for 6 hours. Thermal has designed a new lid for the T6 carrier that allows for easier drinking and pouring. The cost to produce the new lid is $2.19:

Plato Plastics has approached Thermal and offered to produce the 120,000 lids Thermal will require for current production levels of the T6 carrier, at a unit price of $1.75 each. Is this a good deal? Should Thermal buy the lids from Plato rather than produce them themselves? Initially, the $1.75 presented by Plato seems like a much better price than the $2.19 that it would cost Thermal to produce the lids. However, more information about the relevant costs is necessary to determine whether the offer by Plato is the better offer. Remember that all the variable costs of producing the lid will only exist if the lid is produced by Thermal, thus the variable costs (direct materials, direct labour, and variable overhead) are all relevant costs that will differ between the alternatives.

What about the fixed costs? Assume all the fixed costs are not tied directly to the production of the lid and therefore will still exist even if the lid is purchased externally from Plato. This means the fixed costs of $0.51 per unit are unavoidable and therefore are not relevant. Calculations show that when the relevant costs are compared between the two alternatives, it is more cost-effective for Thermal to produce the 120,000 units of the T6 lid internally than to purchase it from Plato.

By producing the T6 lid internally, Thermal can save $8,400 ($210,000 − $201,600). How would the analysis change if a portion of the fixed costs were avoidable? Suppose that, of the $0.51 in fixed costs per unit of the T6 lid, $0.12 of those fixed costs are associated with interest costs and insurance expenses and thus would be avoidable if the T6 lid is purchased externally rather than produced internally. How does that change the analysis?

In this scenario, it is more cost-effective for Thermal to buy the T6 lid from Plato, as Thermal would save $6,000 ($216,000 − $210,000). The difference in these two presentations of the data emphasizes the importance of defining which costs are relevant, as improper cost identification can lead to bad decisions.

These analyses only considered the quantitative factors in a make-versus-buy decision, but there are qualitative factors to consider as well, including:

• Will the T6 lid made by Plato meet the quality requirements of Thermal?
• Will Plato continue to produce the T6 lid at the $1.75 price, or is this a teaser rate to obtain the business, with the plan for the rate to go up in the future?
• Can Plato continue to produce the quantity of the lids desired? If more or fewer are needed from Plato, is the adjusted production level obtainable, and does it affect the cost?
• Does using Plato to produce the lids displace Thermal workers or hamper morale?
• Does using Plato to produce the lids affect the reputation of Thermal?

In addition, if the decision is to buy the lid, Thermal is dependent on Plato for quality, timely delivery, and cost control. If Plato fails to deliver the lids on time, this can negatively affect Thermal’s production and sales. If the lids are of poor quality, returns, replacements, and damage to Thermal’s reputation can be significant. Without long-term agreements on price increases, Plato can increase the price they charge Thermal, thus making the entire drink container more expensive and less profitable. However, buying the lid likely means that Thermal has excess production capacity that can now be applied to making other products. If Thermal chooses to make the lid, this consumes some of the productive capacity and may affect the relationship Thermal has with the outside supplier if that supplier is already working with Thermal on other products.

“10.3 Evaluate and Determine Whether to Make or Buy a Component” from Principles of Accounting, Volume 2: Managerial Accounting by Open Stax Rice University is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License 4.0, except where otherwise noted.