University of the People

BUS 5110: Management Accounting

May 8, 2024

Differential Analysis for Manufacturing Company seeking to produce Engine Components

Case Study

A vacuum manufacturer has prepared the following cost data for manufacturing one of its engine components

based on the annual production of 50,000 units.

Description Cost Per Month

Direct Materials $75,000

Direct Labor $100,000

Total $175,000

In this case the main decision that needs to be made is whether or not to have a third party manufacture the

engines for the vacuum company. Choosing this will add to the variable costs for each engine, but will reduce

the fixed costs. We can achieve this by applying differential analysis "Differential analysis requires you to think

about all the potential solutions to a particular business opportunity to determine which one is the most cost-

effective. According to Heisinger & (n.d.). Differential revenues and costs represent the difference in revenues

and costs among alternative courses of action. Making decisions is one of the basic functions of a manager. To

be successful in decision-making, managers must be able to perform differential analysis, which focuses on

identifying the costs and benefits that differ between alternatives (Brewer, et. al. 2001).

Let’s review both scenarios from the case study

1. Internal Manufacturing Of Engines

For this calculation we would need to change the cost to match the same increments are the total unit given. We

could do the calculation 2 ways 1 by changing the units produced to a monthly figure by dividing the total units

by 12 or change the direct costs per month to annual costs. For this analysis we will be doing it annually. To do

so, just take the numbers in the box above and multiply all of them by 12.

Description Cost Per Month

Direct Materials $900,000

Direct Labor $1,200,000

Total $2,100,000

NB: Sales Revenue does not change as such it will not be considered in the analysis it remains at sale price *

total unit = $150 * 50,000 = $7,500,000. Differential analysis only considers relevant revenues and cost,

(Brewer, et. al. 2001).

The annual calculation for,

Direct Material = $75,000 *12 = $900,000

Direct Labor = $100,000 * 12 = $ 1,200,000

Total Per Annum = $ 175.000 * 12 =$ $2,100,000

Give that, Variable Factory Overhead = $7.50 per unit

Therefore, Total variable factory overhead = $7.50 * 50,000 = $375,000 per year

Fixed factory overhead applied = 150% of the direct labor cost per unit.

Therefore, Direct labor cost per unit = Total direct labor cost per year/ Total Units
= $1,200,000/ 50,000 = $24

Now, fixed factory overhead per unit = 150% of $24 = (150/100) *$24 = $36

Fixed Factory Overhead (FFO) = $36 * 50,000 = $1,800,000

If the company were to manufacture the engines internally then the costs would be:

Internal Manufacturing = FFO + Total per annum cost+ Variable cost

Internal Manufacturing = $1,800,000 + $2,100,000 + $375,000 = $4,275,000

2. Third Party Manufacturing Engines

If the company decides to have a third party manufacture the engines for them then there are no direct material

or direct labor costs. However there is the cost of paying the third party to build the engines.

Let’s calculate the cost to buy.

We know that the cost to outsource the engines is $60 per engine. For a full year of 50,000 engines, that would

be $3,000,000 in cost. $60 * 50,000 = $3,000,000

If the company chooses to pay the third party company to manufacture the engines instead the fixed annual

factory overhead will only be 75% of the current annual fixed factory overhead.

Third Party FFO = 75% of Current FFO

Third Party FFO = .75($1,800,000)

Third Party FFO = $1,350,000

If the company were going to have a third party manufacture the engines then the costs would be:
External Manufacturing = Payment to Third party + Third Party FFO

External Manufacturing = $3,000,000 + $1,350,000

External Manufacturing = $4,350,000

Alternative 1 Alternative 2 Differential

Buy Engine From
Make Engine internally T/Party Amount

Variable Cost $375,000 $375,000

Cost to buy 0 $3,000,000 -$3,000,000

Direct Material $900,000 $900,000

Direct Labor $1,200,000 $1,200,000

Fix Factory Overhead $1,800,000 $1,350,000 $450,000

Total Production Lower Productio
Cost $4,275,000 $4,350,000 -$75,000 cost

The above analysis show a lower production cost to have the engines manufactured in house, as seen in the

below analysis even from a profit perspective it would be more beneficial to have the units produced internally

as oppose to using a third party.

Alternative 1 Alternative 2
Make Engine internally Buy Engine From T/Party

$7,500,000 $7,500,000
Variable Cost $375,000
Contribution Margin $7,125,000 $7,500,000

Cost to buy 0 $3,000,000

Direct Material $900,000

Direct Labour $1,200,000

Fix Factory Overhead $1,800,000 $1,350,000

Profit Margin $3,225,000 $3,150,000
Recommendation

Based solely on the above financial considerations, it would cost less for the company to make the engines in-

house. Therefore I would recommend that they opt to making the engines in house.

Other Factors to Consider:

1. Quality Control: Making in-house allows for better control over the quality of the engines compared to

outsourcing (Iger, 2021).

2. Long-term Strategy: Investing in in-house manufacturing may provide strategic advantages in the long run,

such as developing proprietary technology or maintaining control over production schedules (Iger, 2021).

3. Risk Management: Relying on a third party for critical components exposes the company to supply chain

risks, such as price fluctuations or delivery delays.

Considering these factors, the decision to make the engines in-house aligns with the company's long-term goals

and risk mitigation strategies.

Reference:

• Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for

Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html

• Brewer, P. C., Garrison, R. H., & Noreen, E. W. (2001). Introduction to managerial Accounting.

http://ci.nii.ac.jp/ncid/BA78027166

• Iger B. 2021, November 1. Make The Case: In-House Services vs. Outsourcing. (n.d.). Performance

Racing Industry. https://www.performanceracing.com/magazine/columns/11-01-2021/make-case-house-

services-vs-outsourcing