The Total Alternatives Approach

In the simple make-or-buy decision in Exhibit 12-6, we assumed that the capacity currently used to make DVD players will remain idle if Soho purchases DVDs from Broadfield. Often, however, the released capacity can be used for other, profitable purposes. In this case, Soho’s managers must choose whether to make or buy based on how best to use available production capacity.

Concepts in Action

Starbucks Brews Up Domestic Production^*

Andrew Winning/Reuters/Alamy Stock Photo

After years of outsourcing production to lower-cost countries around the world, many American-based companies are relocating their manufacturing activities within the United States. Starbucks, the world’s largest coffee chain, is a leader in the domestic outsourcing movement. In 2012, the company began sourcing its coffee mugs from American Mug and Stein, a reopened ceramics factory in northeastern Ohio. Starbucks also built a $172 million facility in Georgia to produce its ready-brew VIA coffee and the coffee base for its Frappuccino blended beverages.

While labor costs at the Ohio and Georgia plants are higher than in many offshore locations, there are several cost-savings benefits from domestic production. These include

Access to highly skilled labor, which helps with production efficiency;
Reduced transportation and warehousing costs, since more than 50% of Starbucks’ retail stores are in the United States;
Greater speed to market, which cuts lead time and inventory carrying costs.

While many companies continue to benefit from the global supply chain, Starbucks is among many United States-based companies, including American Apparel and Ralph Lauren, that have benefited from having domestic manufacturing and outsourcing as part of their production mix.

Example 3

If Soho decides to buy DVD players for its 2-in-1 systems from Broadfield, Soho’s best use of the capacity that becomes available is to produce 100,000 Digiteks, a portable, stand-alone DVD player. From a manufacturing standpoint, Digiteks are similar to the DVD players Soho currently makes for its 2-in-1 system. Soho’s management accountant estimates the following future revenues and costs if Soho decides to manufacture and sell Digiteks:

The table depicts estimated future revenues and costs if Soho decides to manufacture and sell Digiteks. The details of the table are as follows:

1. Incremental future revenues: 8,000,000 dollars

2. Incremental future costs

Direct materials: 3,400,000 dollars
Variable direct manufacturing labor: 1,000,000 dollars
Variable overhead, such as power and utilities: 600,000 dollars
Materials-handling and setup overheads: 500,000 dollars
Total incremental future costs: 5,500,000 dollars

3. Incremental future operating income: 2,500,000 dollars

Because of capacity constraints, Soho can make either DVD players for its 2-in-1 system unit or Digiteks, but not both. Which of the two alternatives should Soho’s managers choose: (1) make DVD players for its 2-in-1 system and do not make Digiteks or (2) buy DVD players for its 2-in-1 system and make Digiteks?

Exhibit 12-7, Panel A, summarizes the “total-alternatives” approach, the future costs and revenues for all products. Soho’s managers will choose alternative 2, buy DVD players for its 2-in-1 system and use the available capacity to make and sell Digiteks. The future incremental costs of buying DVD players for its 2-in-1 system from an outside supplier ($16,000,000) exceed the future incremental costs of making 2-in-1 system DVD players in-house ($15,000,000). But Soho can use the capacity freed up by buying DVD players for its 2-in-1 system to gain $2,500,000 in operating income (incremental future revenues of $8,000,000 minus total incremental future costs of $5,500,000) by making and selling Digiteks. The net relevant costs of buying 2-in-1 system DVD players and making and selling Digiteks are $$ 16,000,000 - $ 2,500,000 = $ 13,500,000 .$

Table shows the two approaches under panels A and B to analyze the alternatives faced by Soho Company by listing the future costs and revenues of all products.

The details of the two approaches and the related alternatives listed in the table are as follows:

Relevant Item: PANEL A Total-Alternatives Approach to Make-or-Buy Decisions

1. Alternatives for Soho: Make video-system DVD players and do not make Digiteks

• Total incremental future costs of making/buying video-system DVD players: $15,000,000

• Deduct excess of future revenues over future costs from Digiteks: $0

• Total relevant costs under total-alternatives approach: $15,000,000

2. Alternatives for Soho: Buy video-system DVD players and make Digiteks

• Total incremental future costs of making/buying video-system DVD players: $16,000,000

• Deduct excess of future revenues over future costs from Digiteks: $2,500,000 within parentheses

• Total relevant costs under total-alternatives approach: $13,500,000

Relevant Item: PANEL B Opportunity-Cost Approach to Make-or-Buy Decisions

1. Alternatives for Soho: Make video-system DVD players

• Total incremental future costs of making/buying video-system DVD players: $15,000,000

• Opportunity cost: Profit contribution forgone because capacity will not be used to make Digiteks, the next-best alternative: $2,500,000

• Total relevant costs under opportunity-cost approach: $17,500,000

2. Alternatives for Soho: Buy video-system DVD players

• Total incremental future costs of making/buying video-system DVD players: $16,000,000

• Opportunity cost: Profit contribution forgone because capacity will not be used to make Digiteks, the next-best alternative: $0

• Total relevant costs under opportunity-cost approach: $16,000,000