Cost Analysis for Competing Alternatives

To make decisions, managers “focus on those costs and revenues that are relevant to the decisions” (Horngren, Harrison & Oliver, 2009, p. 995). And for luscious creamery the relevant costs for the make decision include the cost of raw materials, labor, and overheads incurred in production of the packages. For the ‘buy’ decision the costs would include the purchase price and the transportation cost to the entity where such is not included in the purchase price. For decision making purposes such costs are dividend into variable (those that change with change in level of output e.g. direct materials) and fixed (those that are not determined by the production level e.g. rent and insurance) components.

Manufacturing versus Outsourcing where Fixed costs Remain Constant

On average luscious creamery (hypothetical company) daily output is 500,000 liters of processed milk after spillages and farmer’s deliveries that do not meet the company’s standards are eliminated. This implies that the company would require one million packages for each day (500,000, x 1000 / 500). For production of these packages the costs attributable to the process are as in the table below:

Table 1: Relevant costs for manufacturing alternative

Particulars Costs ($)(2,000,000 packages)
Direct materials 160,000
Direct labor 80,000
Variable manufacturing overheads 60,000
Fixed manufacturing overheads 200,000
Total manufacturing costs 500,000
Number of packages 1,000,000
Unit (package) cost 0.5

Modeled after (Bamber, Braun & Harrison, 2007, p. 437; Horngren, Harrison & Oliver, 2009, p.1015).

Due to their specialization in making packages; the company that luscious creamery seeks to outsource the package production from, undertakes to provide each package at $ 0.4 inclusive of the cost of transportation to the processing plant. Though on ‘face value’ the entity should outsource package production since the value offered by the supplier ($ 0.4) is $ 0.1 lower than the unit cost on production ($ 0.5); the decision to make or buy must come after analysis of other contributory factors. For instance management must consider how variable costs compare to the cost of outsourcing, whether by outsourcing the company will avoid fixed costs and the use that the resultant free capacity will be put into (Bamber, Braun & Harrison, 2007).

Taking into account such concepts various scenarios can arise. First by outsourcing the company will avoid all variable production costs $ 300,000 (direct materials, direct labor and variable overheads). Such a saving translates to $ 0.30 per package ($300,000/1000000 packages). Assuming the fixed costs for the company do not change following the outsourcing decision; then luscious creamery would better do in-house production since the amount saved on outsourcing ($ 300, 000 or $ 0. 30 per package) is lower than the outsourcing cost – the purchase price [$ 400,000 or $ 0.40 per package] (Bamber, Braun & Harrison, 2007).

When Fixed Costs Reduce After Outsourcing

Fixed costs could however change – e.g. reduction in insurance premiums paid with respect to storage of packaging materials. Further some fixed costs such as total electricity comprise variable aspects like the saving that would be generated when production equipment are not running. To make a decision under such a condition then an assumption that luscious creamery would save up to $ 40,000 in fixed costs on outsourcing is made. Such change would then affect the decision that luscious creamery would have to make.

Table 2: Comparison between Manufacture or outsource without use of freed capacity

Particulars Manufacture Outsource Variance
Variable costs:

  • Direct materials
  • Direct labor
  • Variable O/H

Purchase cost

($ 0.4 x 1,000,000)

Fixed overhead

160,000

80,000

60,000

 

200,000

 

$ 400,000

$ 160,000

$ 160,000

$ 80,000

$ 60,000

 

(400,000)

40,000

Total cost of packages $ 500,000 $ 560,000 $ (60,000)

Modeled after (Bamber, Braun & Harrison, 2007, p. 437; Horngren, Harrison & Oliver, 2009, p.1015).

 

Even after minimizing the fixed costs luscious creamery would spend less if it were to manufacture than out source the packages production. For one million packages, the company would save $ 60,000 through manufacturing. From the analysis it is notable that if the management were to make the decision based on the unit cost alone ($ 0.40 for outsourcing and $ 0.50 for manufacturing) then the decision would be misinformed. By the use of relevant costs applicable to the decision it is evident that the manufacturing option would prove more economical as opposed to the case when only unit costs are considered (Bamber, Braun & Harrison, 2007). Based on this evaluation entities should outsource processes or intermediate products when the incremental cost of outsourcing is lower than the incremental cost of manufacturing and vice versa (Bamber, Braun & Harrison, 2007). Perhaps what would be inquired is what price level that outsourcing packages production for luscious creamery would be more economical than manufacturing these packages. Such would necessitate the analysis of the level at which cost of manufacture would be equal to cost of outsourcing (Bamber, Braun & Harrison, 2007). This can be derived as follows:

Table 3: Outsourcing price level where costs of manufacture equals cost of outsourcing

Particulars Manufacturing                         =                   Outsourcing (OTS)
Variable costs + fixed costs $ 300,000 + 200,0000=(1,000,000 x unit OTS cost) + $ 160,000ð 300,000 + 200,000 – 160,000 = (1,000,000 x unit OTS cost)

ð $ 340,000 = (1,000,000 x unit OTS cost)

ð $ 340,000 ÷ 1,000,000 = unit outsourcing price

= $ 0.34

 

Luscious creamery should thus only accept a price lower than $ 0.34 per package if it intends to seek the package production services from another company. A third scenario would however arise if the company can use the freed capacity after outsourcing to further its core business – milk processing.

When Freed Capacity on Outsourcing is Employed to Increase Milk Processing

To incorporate a scenario where outsourcing would enable the company increase its milk processing; three situations are compared. First is when luscious creamery undertakes to manufacture the packages; second when the entity does not utilize capacity created by outsourcing for any other purpose; and thirdly when the entity employs the capacity freed to increase its milk processing capabilities while still avoiding the $ 40,000 fixed costs related to packages (Bamber, Braun & Harrison, 2007). To cater for the latest addition an assumption that the freed capacity would help the entity process adequate milk to generate an additional $ 70,000 in profits is made. This results in the following comparative table:

Table 4: Decision when freed capacity is used to further other processes

Particulars Manufacturepackages Outsource package production
Leave freed capacity idle Use freed capacity to process more milk
Expected cost of packages (from Table 2)Profit from additional milk output $ 500,000- $ 560,000- $ 560,000$(70,000)
Net cost for 1000,000 packages $ 500,000 $ 560,000 $ 490,000

Modeled after (Bamber, Braun & Harrison, 2007, p. 437; Horngren, Harrison & Oliver, 2009, p.1015).

From this analysis it is evident that luscious creamery should outsource the package production if the freed capacity would help it focus more on its core business – milk processing. By increasing its output through the use of freed capacity after outsourcing package production; the entity is able to generate $ 70,000 profits which it would have foregone if the freed capacity was not alternatively used (Bamber, Braun & Harrison, 2007). Go to conclusion here.

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