January 10th, 2018
Cost analysis for Demwalt’s Outsourcing – Insourcing Strategy
The outsourcing/in-house-production decision involves analysis of various costs that accrue to alternative decisions. In the case of Demwalt, the cost analysis for in-house production involves allocation of factory and administrative overheads to the three work cells that are involved in the manufacture of R series pistons, in addition to the direct costs that are attributed to these cells. Whereas direct costs are simple to allocate due to their direct relation to the expected demand (quantity of pistons), the allocation of factory and administrative overheads is complicated, since such costs may not be traceable back to the respective piston unit that necessitated their incurrence. Of such overheads, there existed two different categories – those that may not be traced to the work cells (e.g. administrative salaries, insruance and taxes), and those that could be traced to the work cells (e.g. depreciation, machinery repairs and preventive maintenance).
For the overhead costs that could not be traced to the three work cells, allocation to the work cells was based on three cost bases – direct labor (28% of such costs), Floor space (25 % of relevant costs) and plant volume (23 % of relevant costs). The identified bases of allocation allowed for the allocation of the overheads such as insurance, utilities, taxes and engineering staff salaries. For instance, Utilities and Insurance were allocated based on the floor space following the assumption that overheads in these two categories, accrue from each department based on the space it occupies, which may contribute to aspects such as electricity bulbs that operate in the department. Insurance for instance covers Dewalt’s entire operations, the premiums paid being independent of the activity that occurs in different departments. Similarly, Utilities such as water and telephone, though usage could differ from department to another, may prove challenging to allocate effectively through the identified alternatives (plant volume and direct labor). The second allocation basis was direct labor, which was used as the criterion to allocate administrative staff and staff engineering costs. Similar to direct labor, salaries for administrative and engineering staff may be perceived to accrue on hourly rates thus enabling their comparison. Thirdly, plant volume was employed to allocate taxes and plant maintenance costs. The reasoning behind this allocation was that increased productivity could affect these aspects. Taxes, for instance, may increase when more production necessitated by demand, results into a higher profit. With such an increased productivity, plant components such as machinery would also require maintenance that is more regular.
Other overheads, whose relevant values for work cells involved in piston production, could be readily identified, included depreciation, carrying charge of raw materials (alloy), ordering costs of raw materials and the cost of transporting raw materials to the factory/warehouse. Depreciation for machinery at the three work cells amounted to $ 150, 000 during each year, following a straight-line depreciation policy (Appendix, table1; case study). Alloy ordering costs were also estimated to remain constant (at $ 18000) through the period for which the outsourcing/insourcing analysis was conducted. Other overheads required various adjustments before being allocated to the work cells.
Various adjustments were necessitated in respect to some of the overheads to reflect a fair position of in-house/outsourcing costs. For plant maintenance, the value allocated using the 23% criterion was, as an example, adjusted for preventative maintenance costs and machine repair costs, since additional information available, allowed the contribution of work cells to such costs to be demarcated. Similarly, estimated yearly increment in various costs (e.g. 3 percent annual increase in administrative staff, staff engineering and plant maintenance), were accounted for before allocation to the work cells was considered. Inventory carrying cost for raw material (alloy) was also calculated based on the assumption that the demand was evenly distributed throughout the year for each year. Other challenges encountered in allocating overhead to work cells included overheads that could not be traced to the categories provided under the “total factory and administrative” subheading. Such for instance included the ordering costs which may involve both labor costs for preparing local purchase orders as well as utilities such as phone calls made to facilitate delivery.
The allocation of overheads to the work cells could bear significant implications for the outsourcing/insourcing decision. Firstly, such allocation means that the total cost for in-house-production increases relative to that of outsourcing, even where these costs are not eliminated by outsourcing. Specifically, the allocation of non-manufacturing overheads such as administrative staff salaries to the in-house-production option, could make this alternative seem unfavorable as compared to outsourcing, though such administrative costs may remain unaltered by outsourcing. Secondly, lack of effective ways to track non-manufacturing overheads to the work cells could lead to over or under estimation of the actual costs that arose out of the process under consideration. An example for Demwalt is the allocation of utilities. Despite the perspective that floor space could be a pointer to the installation of utilities, such may not be a credible measure where the use of some utilities is considered. For instance, electricity usage may be in proportion to the number of hours that machines run, which in turn may be considered to be based on the activity of each department. Due to such uncertainties in allocating overheads, especially those not related to production processes, the cost for in-house alternative could become either overstated or underestimated. When this is the case, unattractive outsourcing alternative may be chosen over in-house production or a credible one disregarded – a factor that could affect the competitive advantage the company wished to access from the alternative chosen.
For outsourcing alternative, various costs accrue. Firstly, the purchase price of pistons based on the expected demand is estimated to be $ 3,660,000 and $ 4,209,000 for year one and two respectively (appendix , table 2). The safety stock carrying charge, based on the average monthly demand, and the assumption that demand is evenly distributed throughout the year for year one and two, leads to costs of $ 54900 and $ 63,135 respectively (Appendix, table 2). Whereas the estimates for ordering costs remain constant at $ 18000 (12 months at $1500 per month), the buyer’s compensation (inclusive of the 40 % benefits) is estimated to increase by 3% from year one to two. Since for every one million parts supplied, 1500 cases of defects are projected to occur, the estimated cost for such defects under the projected demands for year one and two are $112,500 and $129,375 respectively (appendix, table 2). Other costs relevant to the outsourcing decision include tooling charge, inventory carrying charge (calculated based on the average monthly inventory Appendix table 3), and buyer’s compensation (Appendix table 2). Since the management is yet to determine an alternative use for the capacity freed by outsourcing, the contribution that any such use could have had on the outsourcing decision is left out. Where such is the case, the outsourcing alternative is bettered by the contribution that the alternative use brings to the entity.
Following the analysis of both the in-house production and outsourcing costs, outsourcing pistons seems to be the better alternative for Demwalt. Through outsourcing the pistons, Demwalt could save $ 450,689.99 in costs during the first year and $ 209, 072.40 in the second year. Despite this observation, various aspects may adversely affect the favorable rating of the outsourcing alternative. Firstly, regards the reliability of the estimated demand upon which calculations were based. According to historical indicators (noted in the case), such estimates could deviate by as much as 15% in either side. The impact of this is that, with quantity being a critical consideration in ascertaining the breakeven point, a lower demand could imply that costs exceed the expected gains. Other factors that would affect the decision in case of Demwalt are considered below. Go to part 3 here.