Dr.JAYARAM.A.

Surana College, Department of MBA CHAPTER-5

Contact num- 9620843555 Bangalore University, Bangalore
Make or Buy
1. Nitin Ltd. manufactures electric pumping sets. The company has the
option to either make or buy from the market component Y used in
manufacture of the sets.
The following details are available:
The component will be manufactured on new machine costing Rs. 1 Lakh with
a life of 10 years. Material required cost of Rs. 2 per kg and wages Rs. 0.30
per hour. The salary of the foreman employed is Rs. 1,500 per month and
other variable overheads include Rs. 20,000 for manufacturing 25,000
components per year. Material requirement is 25,000 kgs and requires 50,000
labour hours.

The component is available in the market at Rs. 4.30 per piece.

Will it be profitable to make or buy the component? Does it make any
difference if the component can be manufactured on an existing machine.

Solution:
Cost estimates

Amount
Particular Per Piece
(Rs.)
a. Material Cost (25,000 x 2) 50,000
b. Wages (50,000 x 0.30) 15,000
c. Salary (1,500 x 12) 18,000
d. Other variable overheads 20,000
Manufacturing Cost (1,03,000/25,000) 1,03,000 4.12
Fixed Cost (working note) 10 years
(80,102 / 2,50,000 unit) 0.32
Making Cost 4.44

Comment:

If new machine used to If existing machine used to

manufacture the product manufacture the product
Make 4.44 4.12
Buy 4.30 4.30
Buy Make

Make or Buy 1
Dr.JAYARAM.A.
Surana College, Department of MBA CHAPTER-5
Contact num- 9620843555 Bangalore University, Bangalore
Working note:

Fixed cost
Machinery cost Rs. 1,00,000
Rate of Depreciation: 15%
No. of years: 10 years

Normal Dep 1,00,000x 15% = 15,000

Additional Dep 1,00,000x 20% = 20,000

Tax Saving on Present value

Amount of P.V factor
Year Depreciation of tax saving
Depreciation @10%
(31.2%) (10%)
1 35,000 10,920 0.909 9,927
2 9,750 3,042 0.826 2,512
3 8,288 2,586 0.751 1,942
4 7,044 2,198 0.683 1,501
5 5,988 1,868 0.621 1,160
6 5,090 1,588 0.564 895
7 4,326 1,350 0.513 692
8 3,677 1,147 0.467 536
9 3,126 975 0.424 413
10 2,657 829 0.386 320
19,898

Present value of cash outflow Rs. 1,00,000

Less: Present value of tax saving Rs. 19,898
Rs. 80,102

Make or Buy 2
Dr.JAYARAM.A.
Surana College, Department of MBA CHAPTER-5
Contact num- 9620843555 Bangalore University, Bangalore

2. XYZ Ltd. Needs a component in an assembly operation. It is

contemplating the proposal to either make or buy the aforesaid component.
a. If the company decides to make the product itself, then it would need
to buy a second hand machine for Rs. 8 Lakh which would be used for 5
years. Manufacturing costs in each of the five years would be Rs. 12 lakh, Rs.
14 lakh, Rs. 16 lakh, Rs. 20 lakh and Rs. 25 lakh respectively. The relevant
depreciation rate is 15%. The machine will be sold for Rs. 1 lakh at the
beginning of the sixth year.
b. If the company decides to buy the component from a supplier the
component would cost Rs. 18 lakh, 20 lakh, Rs. 22 lakh, Rs. 28 lakh and Rs.
34 lakh respectively in each of the five year.
c. The relevant discounting rate and tax rate are 14% and 32.445%
respectively. Additional depreciation is not available. Should XYZ ltd. Make
the component or buy from outside?
Solution:
Calculation of Depreciation
Value of machine = Rs. 8,00,000
Rate = 15%
Value of the Machine 8,00,000
Less: 1 yr Depreciation (8,00,000 x 15%)
st 1,20,000
6,80,000
Less: 2nd yr Depreciation (6,80,000 x 15%) 1,02,000
5,78,000
Less: 3rd yr Depreciation (5,78,000 x 15%) 86,700
4,91,300
Less: 4th yr Depreciation (4,91,300 x 15%) 73,695
4,17,605
Less: 5th yr Depreciation (4,17,605 x 15%) 62,640
3,54,965

Calculation of Present value of Cash outflow (Make)

Yr Manufacturing Depreciation Tax Saving D = A -C P.V. P.V. of
cost (A) (B) @ 32.445% @ Cash
(C) 14% outflow
0 8,00,000 -- -- 8,00,000 1 8,00,000
1 12,00,000 1,20,000 4,28,274 7,71,726 0.877 6,76,804
2 14,00,000 1,02,000 5,47,250 9,12,678 0.769 7,01,848
3 16,00,000 86,700 5,47,250 10,52,750 0.675 7,10,606
4 20,00,000 73,695 6,72,810 13,27,190 0.592 7,85,696
5 25,00,000 62,640 8,31,449 16,68,551 0.519 8,65,978
1,00,000 0.519 (51,900)
P.V. of Cash outflow 44,89,032

Make or Buy 3
Dr.JAYARAM.A.
Surana College, Department of MBA CHAPTER-5
Contact num- 9620843555 Bangalore University, Bangalore

Tax Savings @ 32.445%

1 3,89,340 + 38,934 = 4,28,274
2 4,54,230 + 33,094 = 4,87,324
3 5,19,120 + 28,130 = 5,47,250
4 6,48,900 + 23,910 = 6,72,810
5 8,11,125 + 20,324 = 8,31,449

Calculation of Present value of Cash outflow (Buy)

Yr Purchase Tax Saving @ C=A-B P.V. @ P.V. of Cash
cost (A) 32.445% (C) 14% outflow

1 18,00,000 5,84,010 12,15,990 0.877 10,66,423

2 20,00,000 6,48,900 13,51,100 0.769 10,38,996
3 22,00,000 7,13,790 14,86,210 0.675 10,03,192
4 28,00,000 9,08,460 18,91,540 0.592 11,19,791
5 34,00,000 11,03,130 22,96,870 0.519 11,92,076
P.V. of Cash outflow 54,20,478

Comment:

If second hand machine used to

manufacture the product
Make 44,89,032
Buy 54,20,478
Make

If the company manufacture the product they can save (54,20,478 –

44,89,032) Rs. 9,31,446. Hence the company need to make the product
rather than buy the product.

Value of the machine at the beginning of 6th year 3,54,965

Less: Sale of machine 1,00,000
Short term capital loss 2,54,965

2,54,965 x 32.445% =Rs. 82,723

Make or Buy 4
 Dr.JAYARAM.A.
Surana College, Department of MBA CHAPTER-5
Contact num- 9620843555 Bangalore University, Bangalore
3. DJP Ltd. needs a component in an assembly operation. It is
contemplating the proposal to either make or buy the aforesaid component.
i. If the company decides to make the product itself, then it would need
to buy a new machine for Rs. 15 Lakh which would be used for 5 years.
Manufacturing costs in each of the five years would be Rs. 24 lakh, Rs. 28
lakh, Rs. 32 lakh, Rs. 40 lakh and Rs. 50 lakh respectively. The relevant
depreciation rate is 15%. The machine will be sold for Rs. 1.5 lakh at the
beginning of the sixth year.
ii. If the company decides to buy the component from a supplier the
component would cost Rs. 30 lakh, 30 lakh, Rs. 32 lakh, Rs. 34 lakh and Rs.
50 lakh respectively in each of the five year.
iii. The relevant discounting rate and tax rate are 15% and 31.2%
respectively. Additional depreciation is not available. Should XYZ ltd. Make
the component or buy from outside?
Solution:
Calculation of Depreciation
Value of machine = Rs. 15,00,000
Rate = 15%
Value of the Machine 15,00,000
Less: 1st yr Depreciation (15,00,000 x 15%)
2,25,000 + 3,00,000 5,25,000
9,75,000
Less: 2nd yr Depreciation (9,75,000 x 15%) 1,46,250
8,28,750
Less: 3rd yr Depreciation(8,28,750 x 15%) 1,24,313
7,04,437
Less: 4th yr Depreciation (7,04,437 x 15%) 1,05,665
5,98,772
Less: 5th yr Depreciation (5,98,772 x 15%) 89,816
5,08,956

Calculation of Present value of Cash outflow (Make)

Yr Manufacturing Depreciation Tax Saving D = A -C P.V. P.V. of
cost (A) (B) @ 31.2 % @ Cash
(C) 15% outflow
0 15,00,000 - - 15,00,000 1 15,00,000
1 24,00,000 5,25,000 9,12,600 14,87,400 0.869 12,92,550
2 28,00,000 1,46,250 9,19,230 18,80,770 0.756 14,21,862
3 32,00,000 1,24,313 10,37,185 21,62,815 0.657 14,20,969
4 40,00,000 1,05,665 12,80,967 27,19,033 0.572 15,55,287
5 50,00,000 89,816 15,88,022 34,11,978 0.497 16,95,753
1,50,000 0.497 (74,550)
88,11,871

Make or Buy 5
Dr.JAYARAM.A.
Surana College, Department of MBA CHAPTER-5
Contact num- 9620843555 Bangalore University, Bangalore
Tax Savings @ 31.2 %
1 7,48,800 + 1,63,800 = 9,12,600
2 8,73,600 + 45,630 = 9,19,230
3 9,98,400 + 38,785 = 10,37,185
4 12,48,000 + 32,967 = 12,80,967
5 15,60,000 + 28,022 = 15,88,022

Calculation of Present value of Cash outflow (Buy)

Yr Purchase Tax Saving @ 31.2 C=A-B P.V. @ P.V. of Cash
cost (A) % 15% outflow

1 30,00,000 9,36,000 20,64,000 0.869 17,93,616

2 30,00,000 9,36,000 20,64,000 0.756 15,60,384
3 32,00,000 9,98,400 22,01,600 0.657 14,46,451
4 34,00,000 10,60,800 23,39,200 0.572 13,38,022
5 50,00,000 15,60,000 34,40,000 0.497 17,09,680
P.V. of Cash outflow 78,48,153

Comment:

If new machine used to manufacture the

product
Make 88,11,871
Buy 78,48,153
Buy

If the company buy the product they can save (88,11,871 – 78,48,153) Rs.
9,63,718. Hence the company need to buy the product rather than make the
product.

Value of the machine at the beginning of 6th year 5,08,956

Less: Sale of machine 1,50,000
Short term capital loss 3,58,956

3,58,956 x 31.2% =Rs. 1,11,994

Make or Buy 6