 Hello and welcome to the session in which we would look at differential analysis and specifically we're going to be looking at make or buy decision and in the business term we call this outsourcing. This topic is covered on the cost and a cost accounting course as well as the CPA exam, BEC section. As always, I'm going to remind you to connect with me on LinkedIn and check out my YouTube where I have 1800 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. Look, if they're benefiting you, it means they might benefit other people. Please share the wealth. On my website farhatlectures.com, you will find additional resources to complement and supplement this course as well as other accounting and finance courses. I strongly suggest you check out my website. So let's take a look at make or buy decision or outsourcing. What are the decision goals? What should we do? Well, we should choose the option with the lowest relevant costs and hopefully we all know what relevant costs are. If not, I'm going to remind you about relevant costs in a moment. That's the first thing we look at. We have compared the relevant costs and we take into account qualitative consideration on the good thing about being in school. You don't have to worry about qualitative consideration. All you have to worry about is the quantitative, the relevant cost. But in the real world, you have to take a look into account if there's any factors other than the numbers that will help you reject or accept make or buy offer. So remember the relevant costs are the differential costs. And what are the differential costs? Usually they are the direct labor, direct material, variable overhead. Usually the variable cost. Why? Because variable cost varies with your production. So if you are going to be buying it, those will be eliminated, should be eliminated. Also, you have to take a look to see if you can eliminate some of the fixed costs. Some of the fixed costs might be eliminated as a result of buying the product. Because if you are using a building, you may just end your lease in that building and you're not using it anymore. You may cancel the lease and move out and remove that fixed cost. That's a possibility. But again, in our situation, you're going to be told in the problem whether the fixed cost is eliminated or not. And obviously you have to take into account your buying it to purchase price. How much are you paying for it? Usually those are the three factors that you would look into when you are making make or buy decision. The best way to illustrate this is to look at an actual example. Cube manufacturing usually produces its own parts of assembly. The following data are available for the parts. This is the manufacturing cost. They have a variable cost of $6 per unit and they have a fixed cost of $15,000. Non-manufacturing cost, there's a variable cost of $1 fixed cost of $9,000. And this is the fixed cost. Again, we could always assume, not assume, but generally speaking, variable costs will be eliminated if you buy the product. Cube needs 2,000 units every month and outside supplier offers to deliver that part for $1150. What should we do? Should we accept the offer or not accept the offer? Cube can also save half of the fixed manufacturing cost. So this fixed manufacturing cost is $15,000. If we buy, we no longer have to worry about half of it, so we could eliminate $15,000. We still have the other $15,000. There's nothing we can do about this $9,000. Fixed non-manufacturing are not affected. So what should we do? Well, we have to compare between two alternatives. What we are doing now and the alternative, what are we are doing now? Well, right now, we are incurring variable cost of $7, which is 6 plus 1 times 2,000 unit, which is equal to $14,000. So the variable cost right now is $14,000. We have $15,000 and $9,000 of fixed cost, that's $24,000. In total, let's see in total, how much would that be? In total, we'll have, right now, it's costing us $38,000. What is the alternative? Well, the alternative, if we buy from another party, we no longer have any variable cost. That's going to be gone. The fixed manufacturing, the fixed cost, some of it will be eliminated. Remember, we're going to keep the $7,500 of the non-manufacturing and the non-manufacturing will stay with us all of it. So we're going to have $16,500 of fixed cost. Plus, we're going to have to buy the product of $423,000. So if we buy, the factor is $39,500, the total cost. So basically, if we look at the difference, variable cost will be lower, fixed cost will be lower, but the purchase price will be higher by $23,000. The net is a higher of $1,500. Now the question is, what should you do? Based on the numbers, based on strictly quantitative numbers, you would reject. You don't want to buy from an outside party. Now, why would you buy? Well, there are other non-qualitative factors. For example, the quality of the unit, maybe this company that you are buying from, part A31, and that's all what they do. And because that's all what they do, they may be specialized into this product. And as a result, they might have a better quality. And as a result, it might be worth it for you to pay the $1,500. Also, if you outsource, you may simplify and streamline your operation. You have one less thing to worry about. Therefore, maybe it's worth $1,500, this extra money to pay to streamline and make your process much, much smoother at your company. Let's add an assumption here. If the facility used to produce part A31 can be leased out to generate a monthly rental income of $3,000, what should we do under those circumstances? Now we're changing the scenario. We are saying what happened if you do buy, you could lease this extra space for $3,000. Well, guess what? What are you doing now? Well, right now, basically this $3,000 is an opportunity cost. This is a good example of an opportunity cost. Simply put, because you are producing the product yourself, it's taken up a space. Because it's taken up a space, there's an opportunity cost that you are missing out. And what's that opportunity cost? The next best thing you can do with that space is rent it for $3,000, lease it out. Therefore, what it's really costing you, your true cost is the $14,000, the $24,000. Plus, there's an opportunity cost of $3,000. Therefore, your true cost is $41,000. That's your true cost, assuming you take into account opportunity cost. If you buy it, it's going to cost you same computation, $39,500. Now what happened is this? Now we change our computation. And as a result, we find out that you are better off buying the product because you are at $1,500 lower. Now, another way to look at this $3,000 is to say, well, it doesn't have to be an opportunity cost. Really, what's going to happen? It's going to be an extra income for you because you can rent the property. Basically, it's a reduction here. So whatever you have the $3,000 as an opportunity cost here or the $3,000 as a savings under buying it, because you have extra income, it's going to cost you less to buy, it doesn't matter. The answer will be $1,500 lower. Now the question is, what should you do? If you're taken into account this $3,000, should you buy or should you not buy? Again, you have to take into account the quality of the suppliers. And remember, now you have to worry about renting the property at $3,000. So you have to find a tenant. If you find a tenant, what happens if you have a bad tenant? They don't pay. They give you a lot of problems. So that could be an issue. Also, when you buy from another company, their problems become your problem in what sense? Once you rely on them, anything that happened at that company like a strike or there's a change of management and as a result, now they have inferior product. That's going to affect you. Also, because you are buying from them, you have to worry about the logistics. How are they going to deliver it to you? What if there's any problem in the supply chain? Let's assume you are relying on from someone in China and we are living through COVID. What's going to happen to your supply chain? Well, your product, they may or may not be able to deliver the product. So that's why you have to take into account other factors than just the numbers. That's the point that I'm trying to make. So again, what I'm going to do, I'm going to invite you to like this recording. If you like it, share it. And also, I'm going to remind you to visit my website, farhatlectures.com for additional resources for this course as well as your other courses. If you're studying for your CPA exam, I strongly suggest you check out my website, make an investment in your career. It's a 30 to 40 year investment if you pass the exam. Don't shortchange yourself. Good luck. Study hard. And most importantly, stay safe. Thank you.