Now, let's proceed and analyze the case when we buy these relays from company Alpha, Beta, Gamma. But we will use the fried facilities to produce switches for another company that is willing to buy them from us. So, this is make or buy two. So, we make switches and so 6,000 at $15 a piece. Let's see what we have now and we analyze our incremental. So expected incremental revenue. Well, this is clear this is $90,000 multiplied $15 by 6000. Now, what are expected incremental costs? Well, here we have some components and let's say direct materials will be $36,000, now direct labor stands at $6,000, a variable overhead $18,000 and mixed overhead $6,000. We already know that fixed overhead is irrelevant. So, now we can see that total incremental costs are $66,000 and therefore we have expected incremental operating income of $24,000. So, that is kind of cool because remember we said that if we bought 5,000 relays from company Alpha, Beta, Gamma we would save just $17 a piece instead of $20 and therefore we may have sort of quoted loss of about 5,000 because 5,000 pieces and a dollar a piece. Here we make an additional $24,000. So, it seems that the combined decisions or the choice of selling switches to a third company and buying relays from Alpha, Beta, Gamma for us seems to be the best choice. Let's go ahead and analyze the all these choices. So, we have three options. Option one is, make relays and then do nothing else. Then option two, buy relays from Alpha, Beta, Gamma and then do nothing else. Then option three, we buy relays plus make switches and sell them. So, what do these alternative give us? Let's say this is the alternative and these are irrelevant costs. Now, this is alternative one, this is alternative two and this is an alternative three. Let's see what do we have here. Well, first of all we start at total cost for relays and if we may total irrelevant costs, these are only relevant costs and for alternative one if we make them in cost, so this is $85,000. Remember the total is 100 but 15 are irrelevant. If we buy them versus $90,000, if we buy and make switches this is also $90,000, so this is the first part. Then there are also future expected incremental revenues. So, if we take option one, we make relays and do nothing, so here there is nothing. For option two, we buy relays and here there is also nothing but in the third case, it's $24,000 and I put that in brackets because this is we count costs. So, the bottom line is the following. So, these are total relevant costs and see what happens. So, in option one, this is $85,000, in option two this is $90,000 and in option three this is just $66,000. So, clearly option three is preferred. We can see that the delta here is plus 19,000 if we compared against this. So, we see the hierarchy all these options. So, this is the worst this is second worst and this is the best option. So, why did this happen? This happens because if we buy relays we free up our facilities and that gives us an option to make something else and compensate part over costs by these additional or incremental revenues. Now, so we can see here how close the idea of the opportunity cost is. So, let's do the following, so the opportunity cost idea. I will redo the previous table keeping that in mind. So, here we have relevant items, and here are two options, so this is make relays, and this is by relays. So, I analyze only these two but then see what happens. So, we start with and here a total incremental costs and here this is remember that was $85,000 from the previous page only colors have been changed but that's all right and this is $90,000. But the next line goes differently and we'll put that the opportunity cost. So this is foregone revenue or better to say revenue less cost, so this is forgone profit. See how that goes. Here this is nothing. When we buy relays because this opportunity stays well, but if we make them by having decided to make these relays in house, we have to use our facilities. So, we forego the opportunity cost of $24,000 and therefore our total relevant costs here are $109,000 and here are just $90,000. So, we see the same difference of $19,000. So we sort of, this is the analysis or the opportunity cost, the previous one was the just incremental costs and revenues but the idea stays the same. We can see that if we decide to buy these relays, then we have the option of adding $24,000 of incremental revenue and if we decide not to buy but do them make them in-house, that sort of freezes our opportunity to make these switches. That does show the inextricable link between the idea of relevance and the idea of the opportunity cost. Now, in what follows, we will apply the idea of relevant costs to some other important areas that are key in valuing projects and companies.
