Insourcing-Versus-Outsourcing and Make-or-Buy Decisions

Learning Objective 3 Explain the concept of opportunity cost and why managers should consider it when making insourcing-versus-outsourcing decisions

in all decisions, it is important to consider the contribution to income forgone by choosing a particular alternative and rejecting others

We now apply the concept of relevance to another strategic decision: whether a company should make a component part or buy it from a supplier. We again assume idle capacity.

Outsourcing and Idle Facilities

Outsourcing is purchasing goods and services from outside vendors rather than insourcing, producing the same goods or providing the same services within an organization. For example, Novartis prefers to manufacture its own medicines (insourcing), but has HCL Technologies manage some of its information technology infrastructure (outsourcing). Honda relies on outside vendors to supply some component parts (outsourcing) but chooses to manufacture other parts internally (insourcing).

Decisions about whether a producer of goods or services will insource or outsource are called make-or-buy decisions. Surveys of companies indicate that managers consider quality, dependability of suppliers to deliver according to a schedule, and costs as the most important factors in the make-or-buy decision. Sometimes, however, qualitative factors dominate management’s make-or-buy decision. For example, Dell Computer buys the Intel Core i9 processor for its computers from Intel because Dell does not have the know-how and technology to make the processor itself. In contrast, to maintain the secrecy of its formula, Coca-Cola does not outsource the manufacture of its concentrate.

Example 2

The Soho Company manufactures a 2-in-1 system consisting of a DVD player and a digital media receiver (that downloads music and video from Internet sites). Columns 1 and 2 of the following table show the expected total and per-unit costs for manufacturing the DVD player. Soho plans to manufacture the 250,000 units in 2,000 batches of 125 units each. Variable batch-level costs of $625 per batch vary with the number of batches, not the total number of units produced.

Broadfield, Inc., a manufacturer of DVD players, offers to sell Soho 250,000 DVD players next year for $64 per unit on Soho’s preferred delivery schedule. Assume that financial factors will be the basis of this make-or-buy decision. Should Soho’s managers make or buy the DVD player?

The table depicts expected total costs of producing 250,000 units in 2,000 batches next year and expected cost per unit (expected total costs of producing 250,000 units in 2,000 batches next year divided by 250,000) for several line items. The details of the table are as follows:

1. Direct materials, 36 dollars per unit times 250,000 units

Expected total costs of producing 250,000 units in 2,000 batches next year: 9,000,000 dollars
Expected cost per unit: 36.00 dollars

2. Variable direct manufacturing labor, 10 dollars per unit times 250,000 units

Expected total costs of producing 250,000 units in 2,000 batches next year: 2,500,000 dollars
Expected cost per unit: 10.00 dollars

3. Variable manufacturing overhead costs of power and utilities, 6 dollars per unit times 250,000 units

Expected total costs of producing 250,000 units in 2,000 batches next year: 1,500,000 dollars
Expected cost per unit: 6.00 dollars

4. Mixed (variable and fixed) batch-level manufacturing overhead costs of materials handling and setup, 750,000 dollars plus the quantity 625 dollars per batch times 2,000 batches

Expected total costs of producing 250,000 units in 2,000 batches next year: 2,000,000 dollars
Expected cost per unit: 8.00 dollars

5. Fixed manufacturing overhead costs of plant lease, insurance, and administration

Expected total costs of producing 250,000 units in 2,000 batches next year: 3,000,000 dollars
Expected cost per unit: 12.00 dollars

6. Total manufacturing cost

Expected total costs of producing 250,000 units in 2,000 batches next year: 18,000,000 dollars
Expected cost per unit: 72.00 dollars

Columns 1 and 2 of the preceding table indicate the expected total costs and expected cost per unit of producing 250,000 DVD players next year. The expected manufacturing cost per unit for next year is $72. At first glance, it appears that Soho’s managers should buy DVD players because the expected $72-per-unit cost of making the DVD player is more than the $64 per unit to buy it. But a make-or-buy decision is rarely obvious. To make a decision, managers need to consider the question “What is the difference in relevant costs between the alternatives?”

For the moment, suppose (1) the capacity now used to make the DVD players will become idle next year if the DVD players are purchased; (2) the $3,000,000 of fixed manufacturing overhead will continue to be incurred next year regardless of the decision made; and (3) the $750,000 in fixed salaries to support materials handling and setup will not be incurred if the manufacture of DVD players is completely shut down.

Exhibit 12-6 presents the relevant-cost computations, which show that Soho will save $1,000,000 by making the DVD players rather than buying them from Broadfield. Based on this analysis, Soho’s managers decide to make the DVD players.

Table shows the cost information related to the relevant items for make-or-buy decision for DVD players at Soho Company.

The various relevant items with their cost information as listed in the table are as follows. The unavailable data have been marked as nil.

1. Outside purchase of parts which is $64 multiplied by 250,000 units

• Total relevant make costs: Nil

• Total relevant buy costs: $16,000,000

• Relevant make cost per unit: Nil

• Relevant buy cost per unit: $64

2. Direct materials

• Total relevant make costs: $9,000,000

• Total relevant buy costs: Nil

• Relevant make cost per unit: $36

• Relevant buy cost per unit: Nil

3. Direct manufacturing labor

• Total relevant make costs: $2,500,000

• Total relevant buy costs: Nil

• Relevant make cost per unit: $10

• Relevant buy cost per unit: Nil

4. Variable manufacturing overhead

• Total relevant make costs: $1,500,000

• Total relevant buy costs: Nil

• Relevant make cost per unit: $6

• Relevant buy cost per unit: Nil

5. Mixed, variable and fixed, materials-handling and setup overhead

• Total relevant make costs: $2,000,000

• Total relevant buy costs: Nil

• Relevant make cost per unit: $8

• Relevant buy cost per unit: Nil

6. Total relevant costs

• Total relevant make costs: $15,000,000

• Total relevant buy costs: $16,000,000

• Relevant make cost per unit: $60

• Relevant buy cost per unit: $64

a. The difference in favor of making DVD players for total make and buy relevant costs is $1,000,000

b. The difference in favor of making DVD players for make and buy relevant costs per unit is $4

Note how the key concepts of relevance presented in Exhibit 12-3 apply here:

Exhibit 12-6 compares differences in expected total future revenues and expected total future costs. Past costs are always irrelevant when making decisions.
Exhibit 12-6 shows $2,000,000 of future materials-handling and setup costs under the make alternative but not under the buy alternative. Why? Because Soho will incur these future variable costs per batch and avoidable fixed costs only if it manufactures DVD players and not if it buys them. The $2,000,000 represents future costs that differ between the alternatives and so are relevant to the make-or-buy decision.
Exhibit 12-6 excludes the $3,000,000 of plant-lease, plant-insurance, and plant-administration costs under both alternatives. Why? Because these future costs will not differ between the alternatives, so they are irrelevant.

A common term in decision making is incremental cost. An incremental cost is the additional total cost incurred for an activity. In Exhibit 12-6, the incremental cost of making DVD players is the additional total cost of $15,000,000 that Soho will incur if it decides to make DVD players. The $3,000,000 of fixed manufacturing overhead is not an incremental cost because Soho will incur these costs whether or not it makes DVD players. Similarly, the incremental cost of buying DVD players from Broadfield is the additional total cost of $16,000,000 that Soho will incur if it decides to buy DVD players. A differential cost is the difference in total (relevant) cost between two alternatives. In Exhibit 12-6, the differential cost between the make-DVD-players and buy-DVD-players alternatives is $1,000,000 $inline style begin inline style left parenthesis ? back space $ text 16,000,000 end text minus $ text 15,000,000 end text back space ). end style$ Note that incremental cost and differential cost are sometimes used interchangeably in practice. When faced with these terms, always be sure to clarify what they mean.

We define incremental revenue and differential revenue similarly to incremental cost and differential cost. Incremental revenue is the additional total revenue from an activity. Differential revenue is the difference in total revenue between two alternatives.