Make-or-buy decisions involve the assessment of whether an organization should continue manufacturing a product or service ‘in-house’, or if it should just buy those from an outside supplier. Show Why Outsource?If an organization is already manufacturing the entire product internally without involving any outside contractor, why should it outsource any of its business processes? Outsourcing can improve the profitability of businesses by:
Qualitative AnalysisOrganizations need to weigh the short-term financial impact of outsourcing against the long term consequences. Several factors influence make-or-buy decisions.
Quantitative AnalysisMake-or-buy decisions must be based on the relevant cost of each option. Relevant costs in make-or-buy decisions include all incremental cash flows. Any cost that does not change as a result of the decision should be ignored such as depreciation and indirect fixed costs. Calculating the relevant cost is the first step in finding the most cost-effective option. Following are examples of relevant costs in make-or-buy decision
Examples of irrelevant costs in make-or-buy decisions are as follows:
Once we sort out the relevant costs in the make-or-buy decision, we need to find which option minimizes the total cost. The approach to finding the optimum solution in an outsourcing problem depends on the number of limiting factors.
ExamplePhone Inc. is a manufacturer of cell phones. Until now the company has manufactured all phone accessories in-house. The company CFO is wondering if it can reduce the manufacturing cost of cell phones by outsourcing the production of 3 accessories: charger, battery, and earphone. The accountant has forecast the following information for the next year.
Direct fixed costs relate specifically to each component. Non-manufacturing overheads represent the allocated share of head office expenses. Outsource Inc. has supplied the following quotation for the supply of the three components.
Based on quantitative analysis: A. How many units of each component should be outsourced? B. If only 3,000 labor hours are available, how many units of each component should be produced internally or outsourced? C. If only 3,000 labor hours and 1,000 machine hours are available, how many units of each component shall be manufactured or outsourced? SolutionA. To find the optimum solution, we need to compare the relevant cost of making each component with the buying price.
As the internal cost of making batteries exceeds the external price of buying, it is beneficial to outsource their production entirely. Chargers and earphones will be produced internally to minimize cost. B. We need to rank the three components for production priority based on the incremental cost per limiting factor. Batteries are excluded from the calculation of production priority because they will be outsourced anyway based on our assessment in Part A.
Self-production of earphones result in higher savings per labor hour compared to chargers which rank them higher in the production priority. Phone Inc. should use labor hours in the production of maximum units of earphones and manufacture chargers only if any surplus labor hours are available.
Once we have calculated the self-manufactured units of each accessory, we can calculate the number of units we need to outsource as the balancing figure.
C. We are going to solve this part of the problem by using the Simplex Method of linear programming because it involves multiple constraints and products. If you are unfamiliar with the basics of linear programming, I suggest you review this lesson. To solve this problem, we first we need to define the objective function and enter data relating to the cost and constraints for each accessory in Microsoft Excel. We then use the Solver function to mark the relevant data as follows: Pressing the Solve button will return you the optimum solution: We cannot cover all aspects of the Simplex Method in this article as the topic deserves a video tutorial of its own which I will be adding soon. Do subscribe to our YouTube channel to catch any updates. Let us know if you have any questions on this topic in the comments below. Share This PostRelated PostsWhich of the following costs is relevant to a makeHence, the cost of production is considered for 'make or buy' decision.
What are the relevant costs for decisionRelevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process.
Which of the following is not relevant cost information in a makeAny costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.
What factors are considered for makeThe production cost and quality problems are the major triggers of a make-or-buy decision. Other factors are managerial decisions and a company's long-term business strategy that dictate the current operations pattern. Historical policy decisions may also compel a company to consider in-sourcing or outsourcing.
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