The foregoing make‐or‐buy analysis is complete only if it is assumed that the productive capacity used to make the ignition switches cannot be converted to another purpose. If there is an opportunity to use this productive capacity in some other manner, then this opportunity cost must be considered. As indicated earlier, opportunity cost is the potential benefit that may be obtained by following an alternative course of action.
To illustrate, assume that through buying the switches, Baron Company can use the released productive capacity to generate additional income of $38,000 from producing a different product. This lost income is an additional cost of continuing to make the switches in the make‐or‐buy decision. This opportunity cost is therefore added to the “Make” column for comparison. As shown in Illustration 20-7, it is now advantageous to buy the ignition switches. The company’s income would increase by $13,000.
ILLUSTRATION 20-7 Incremental analysis—make or buy, with opportunity cost
The qualitative factors in this decision include the possible loss of jobs for employees who produce the ignition switches. In addition, management must assess the supplier’s ability to satisfy the company’s quality control standards at the quoted price per unit.
SERVICE COMPANY INSIGHT
Giving Away the Store?
In an earlier chapter, we discussed Amazon.com’s incredible growth. However, some analysts have questioned whether some of the methods that Amazon uses to increase its sales make good business sense. For example, a few years ago, Amazon initiated a “Prime” free‐shipping subscription program. For a $79 fee per year, Amazon’s customers get free shipping on as many goods as they want to buy. At the time, CEO Jeff Bezos promised that the program would be costly in the short‐term but benefit the company in the long‐term. Six years later, it was true that Amazon’s sales had grown considerably. It was also estimated that its Prime customers buy two to three times as much as non‐Prime customers. But, its shipping costs rose from 2.8% of sales to 4% of sales, which is remarkably similar to the drop in its gross margin from 24% to 22.3%. Perhaps even less easy to justify is a proposal by Mr. Bezos to start providing a free Internet movie‐streaming service to Amazon’s Prime customers. Perhaps some incremental analysis is in order?