09-11-2012, 06:07 PM
Marginal Costing Make or Buy Decisions
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APPLICATION OF MARGINAL COSTING – MAKE OR BUY DECISION
Marginal costing can be applied in the area of fixation of selling price. The next important area
is whether to make or buy decision.
When a company has unused capacity and wants to manufacture some components, it has
two alternatives:
(A) to make within the organization or
(B) to buy from the market.
Often, firms face the question whether to outsource production of a component or continue
to make it in the factory. Comparison of the relevant costs of both the alternatives in such cases
will show whether to continue the existing arrangement or change to buying it, discontinuing the
current production. The answer depends upon whether the firm has the option to use the freed
capacity, profitably, or not.
Solution:
(i) Case when the capacity would remain idle: The total cost is Rs. 800, while its market
price is Rs. 700. Prima facie, it looks it is cheap to buy rather than making the component.
However, analysis shows the correct picture is not so. Fixed costs are sunk costs as they
are already incurred and cannot be saved, in the short run. In other words, firm would
continue to incur fixed costs, whether the firm makes the component or buys it from the
market. Firm cannot utilize the capacity that would be freed, elsewhere, and so remains
idle. Hence, fixed costs are permanent costs that cannot be saved, if not utilized, elsewhere.
So, a real comparison is between the total costs (Rs. 800) and aggregate of market price
(Rs. 700) along with the fixed costs (Rs. 150) that cannot be saved. The aggregate is
Rs. 850. It is not wise to buy at Rs. 850, which can be made at Rs. 800. So, it is desirable
for the firm to continue to make.
There is another way to explain. Compare variable costs (Rs. 650) with market price
(Rs. 700). It is, now, Marginal Costing. Even in this type comparison too, it is desirable for
the firm to continue to make.
OTHER CONSIDERATIONS THAN COST
Besides comparison of price demanded by outsiders and the marginal cost, other considerations
are as under:
(A) Keeping Fixed Costs Controllable, in case Demand Fluctuates: Normally, fixed costs
are not controllable. To keep fixed costs under control, firm adopts a dual policy of making
as well as buying the same product. The firm buys a small quantity, though the price is
marginally higher than the cost at which it can be made.
In case, the firm produces a part or component, there would be some fixed costs, besides
variable costs. Some staff has to be necessarily engaged and staff costs become fixed and
permanent, in nature. Some firms, deliberately, buy from outside to keep the burden of fixed
costs as low as possible. This is the case more, where the product has fluctuations in demand.
The firm produces the minimum estimated requirement and the excess quantity is purchased from
outside. The effect of this policy is a ‘win, win situation’ under both the circumstances.