A firm that is presently buying a product or a part from outside may consider manufacturing that product or part in the firm itself. Such a decision-making alternative requires the firm to know through marginal costing what contribution to fixed costs will result from a 'make' decision.

Make or buy decisions will be taken with the help of marginal costing in the following manner:

1. When the capacity is available and it cannot be utilized for manufacturing other products, then the purchase cost is compared with the marginal cost or the total cost is compared with the purchase cost plus fixed cost of manufacture to take the make or buy decision.

2. When the capacity is available and it can be utilized for manufacture of other products, the purchase price should be compared with the marginal cost of the product plus opportunity cost, i.e., the loss of contribution of other product replaced.

3. When there is no additional capacity available and it is proposed to acquire additional facilities for manufacture, the purchase price should be compared with the marginal cost plus fixed cost likely to be incurred for manufacturing with additional facility.

Make or buy decision is important for the company. So before taking any decision one should consider certain things as:

• The capacity of the company in terms of people, plant, space etc., to achieve the required quantity and quality.

• The differential cost of making or buying the item.

• The opportunity cost of using existing capacity to manufacture alternative items.

• The level of variable overheads, which are charged to the item.

Illustration

RMS Ltd. manufactures sewing machines which have three components.  The following are the data pertaining to these components.

The market offers a good demand for company's product, but the company is not able to supply the products due to the machine capacity limitation.  So the management decided to purchase one component from outside supplier and produce maximum products with the capacity of the bought product.  The purchase price of the three components is: P at Rs.150, Q at Rs.180 and R at Rs.240. You are required to help the company management decide which component to buy from outside. 

Solution

As the contribution of Q is highest, the component Q should be purchased from the suppliers.

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