CHAPTER 9 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING208
As in earlier exhibits, the third approach is to list only the relevant costs, cost savings and any relevant
revenues. This approach is shown in column (3) of Exhibit 9.3 (Section A). This column represents the
differential costs or revenues and it is derived from the differences between columns (1) and (2). In
column (3), only the information that is relevant to the decision is presented. This approach shows that
the additional costs of buying component A are £300000 but this enables costs of £240000 associated
with making component A to be saved. Therefore the company incurs an extra cost of £60000 if it buys
component A from the outside supplier.
We shall now explore what happens when the extra capacity created from not producing component
A has an alternative use. Consider the information presented in Example 9.5 (Case B). The management
of Rhine Autos should now consider the following alternatives:
1 make component A and do not make component Z;
2 outsource component A and make and sell component Z.
Case A
One of the divisions within Rhine Autos is currently negotiating with another supplier regarding outsourcing
component A that it manufactures. The division currently manufactures 10000 units per annum of the
component. The costs currently assigned to the components are as follows:
Total costs of producing
10000 components
(£)
 
Unit cost
(£)
Direct materials AB
Direct labour
Variable manufacturing overhead costs
(power and utilities)
Fixed manufacturing overhead costs
Share of non-manufacturing overheads
Total costs
120000
100000
10000
80000
50000
360000
12
10
1
8
5
36
The above costs are expected to remain unchanged in the foreseeable future if the Rhine Autos division
continues to manufacture the components. The supplier has offered to supply 10000 components per
annum at a price of £30 per unit guaranteed for a minimum of three years. If Rhine Autos outsources
component A, the direct labour force currently employed in producing the components will be made redundant.
No redundancy costs will be incurred. Direct materials and variable overheads are avoidable if component
A is outsourced. Fixed manufacturing overhead costs would be reduced by £10000 per annum
but non-manufacturing costs would remain unchanged. Assume initially that the capacity that is required
for component A has no alternative use. Should the division of Rhine Autos make or buy the component?
Case B
Assume now that the extra capacity that will be made available from outsourcing component A can be used
to manufacture and sell 10000 units of component Z at a price of £34 per unit. All of the labour force
required to manufacture component A would be used to make component Z. The variable manufacturing
overheads, the fixed manufacturing overheads and non-manufacturing overheads would be the same as
the costs incurred for manufacturing component A. Materials AB required to manufacture component A
would not be required but additional materials XY required for making component Z would cost £13 per unit.
Should Rhine Autos outsource component A?
EXAMPLE 9.5
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OUTSOURCING AND MAKE-OR-BUY DECISIONS 209
It is assumed that there is insufficient capacity to make both components A and Z. The appropriate
financial information is shown in Exhibit 9.3 (Section B). You will see that the same costs will be incurred
for both alternatives for direct labour and all of the overhead costs. Therefore these items are irrelevant
and the same amount can be entered in columns (1) and (2) or they can be omitted from both columns.
Note that direct materials AB (£120000) will be incurred only if the company makes component A, so
an entry of £120000 is shown in column (1) and no entry is made in column (2). However, if component
A is bought from the supplier the capacity will be used to produce component Z and this will result in a
purchase cost of £130000 being incurred for materials XY that are required to produce product Z. Thus
£130000 is entered in column (2) and no entry is made in column (1) in respect of materials XY. Also
note that the sales revenue arising from the sale of component Z is shown in parentheses in column (2).
A comparison of the totals of columns (1) and (2) indicates that that there is a net benefit of £30000
from buying component A if the released capacity is used to make component Z.
EXHIBIT 9.3 Evaluating a make-or-buy decision
Section A – Assuming there is no alternative use of the released capacity
    Total cost
of continuing
to make
10000
components
(1)
(£ per annum)
 
Total cost
of buying
10000
components
(2)
(£ per annum)
 
Difference 5
Extra costs/
(savings) of
buying
(3)
(£ per annum)
Direct materials AB
Direct labour
Variable manufacturing overhead costs
(power and utilities)
Fixed manufacturing overhead costs
Non-manufacturing overheads
Outside purchase cost incurred/(saved)
Total costs incurred/(saved) per annum
Extra costs of buying 5 £60000
120000
100000
10000
80000
50000
360000
70000
50000
300000
420000 
(120000)
(100000)
(10000)
(10000)
300000
60000 
Section B – Assuming the released capacity can be used to make component Z
    (1)
Make component
A and do not make
component Z
(£ per annum)
  (2)
Buy component
A and make
component Z
(£ per annum)
  (3)
Difference 5
Extra costs/
(benefits) of
buying
component A
(£ per annum)
Direct materials XY
Direct materials AB
Direct labour
Variable manufacturing overhead costs
Fixed manufacturing overhead costs
Non-manufacturing overheads
Outside purchase cost incurred
Revenue from sales of component Z
Total net costs
120000
100000
10000
80000
50000
360000
130000
100000
10000
80000
50000
300000
(340000)
330000
130000
(120000)
300000
(340000)
(30000)
Extra benefits from buying component A and using the released capacity to make component
Z 5 £30000
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CHAPTER 9 MEASURING RELEVANT COSTS AND REVENUES FOR DECISION-MAKING210
Instead of presenting the information in columns (1) and (2), you can present the relevant costs and
benefits as shown by the differential items in column (3). This column indicates that the extra costs of
buying component A and using the released capacity to make component Z are:
(£)
Outside purchase cost incurred
Purchase of materials XY for component Z
300000
130000
430000
The extra benefits are:
(£)
Revenues from the sale of component Z
Savings from not purchasing materials AB
340000
120000
460000
The above alternative analysis also shows that there is a net benefit of £30 000 from buying component
A if the released capacity is used to make component Z.
DISCONTINUATION DECISIONS
Most organizations periodically analyse profits by one or more cost objects, such as products or services,
customers and locations. Periodic profitability analysis can highlight unprofitable activities that
require a more detailed appraisal (sometimes referred to as a special study) to ascertain whether or not
they should be discontinued. In this section, we shall illustrate how the principle of relevant costs can
be applied to discontinuation decisions. Consider Example 9.6. You will see that it focuses on a decision
Manufacturing rethinks outsourcing
The economic recession has resulted in original
equipment manufacturers (OEMs) seeking to
drive down costs by re-examining their manufacturing
strategy, with many companies increasing
their level of outsourcing, writes Ronnie Darroch,
Plexus regional president (EMEA) in Electronics
Weekly. He argues that OEMs can be of benefit to
electronic manufacturing service (EMS) providers
(like Plexus who provide electronics design, manufacturing
and after-market services to companies
with high complexity products) as OEMs undertake
strategic reviews and decide to outsource manufacturing
to an EMS provider. Outsourcing all or
a portion of their manufacturing allows OEMs to
convert internal fixed costs to external variable
costs, leaving it more able to deal with changes in
end market demand, particularly during periods of
economic instability. This can create a win–win for
both companies with growth opportunities for the
EMS provider and the OEM left to focus on its core
competencies.
Questions
1 How can
outsourcing
change the cost
structure of an
organization?
2 What are the
major benefits
and limitations of
outsourcing?
Reference
Darroch, R. (2013) ‘Manufacturers rethink outsourcing,
says Plexus, president EMEA’, Electronics Weekly,
11 June, p. 4. Available at www.electronicsweekly
.com/news/business/viewpoints/manufacturers
-rethink-outsourcing-says-plexus-president-emea
-2013-12/
REAL WORLD
VIEWS 9.3
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