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Principles of Accounting, Volume 2: Managerial Accounting

10.3 Evaluate and Determine Whether to Make or Buy a Component

Principles of Accounting, Volume 2: Managerial Accounting10.3 Evaluate and Determine Whether to Make or Buy a Component

One of the most common outsourcing scenarios is one in which a company must decide whether it is going to make a component that it needs in manufacturing a product or buy that component already made. For example, all of the components of the iPhone are made by companies other than Apple. Ford buys truck and automobile seats, as well as many other components and individual parts, from various suppliers and then assembles them at Ford factories. With each component, Ford must decide if it is more cost effective to make that component internally or to buy that component from an external supplier.

This type of analysis is also relevant to the service industry; for example, ADP provides payroll and data processing services to over 650,000 companies worldwide. Or a law firm may decide to hire certain research activities to be completed by outside experts rather than hire the necessary staff to keep that function in-house. These are all examples of outsourcing. Outsourcing is the act of using another company to provide goods or services that your company requires.

Many companies outsource some of their work, but why? Consider this scenario: Today, while driving home from class, one of your car’s engine warning lights goes on. You will most likely take your car to an auto repair specialist to have it analyzed and repaired, whereas your grandfather might have popped the hood, grabbed his toolbox, and attempted to diagnose and fix the problem himself. Why? It is often a matter of expertise and sometimes simply a matter of cost benefit. In your grandfather’s time, car engines were more mechanical and less electronic, which made learning to repair cars a simpler process that required less expertise and only basic tools. Today, your car has many electronic components and often requires sophisticated monitors to assess the problem and may involve the replacement of computer chips or electronic sensors. Thus, you opt to outsource the repair of your car to someone who has the knowledge and facilities to provide the repair more cost effectively than you could if you did it yourself. Your grandfather likely could have made the repair to his car several decades ago as cheaply as the mechanic with only a sacrifice of his time. To your grandfather, the cost of his time was worth the benefit of completing the repair himself.

Companies outsource for the same reasons. Many companies have found that it is more cost effective to outsource certain activities, such as payroll, data storage, and web design and hosting. It is more efficient to pay an outside expert than to hire the appropriate staff to keep a particular task inside the company.

Fundamentals of the Decision to Make or to Buy

As with other decisions, the make-versus-buy decision involves both quantitative and qualitative analysis. The quantitative component requires cost analysis to determine which alternative is more cost effective. This cost analysis can be performed by looking at the cost to buy the component versus the cost to produce the component, which allows us to make a decision based on an analysis of unavoidable costs. For example, the costs to produce will include direct materials, direct labor, variable overhead, and fixed overhead. If the business chooses to buy the component instead, the avoidable costs will go away but unavoidable costs will remain and would need to be considered as part of the cost to buy the component.

Sample Data

Thermal Mugs, Inc., manufactures various types of leak-proof personal drink carriers. Thermal’s T6 container, its most insulated carrier, maintains the temperature of the liquid inside for 6 hours. Thermal has designed a new lid for the T6 carrier that allows for easier drinking and pouring. The cost to produce the new lid is $2.19:

Direct materials $0.87, Direct labor, $0.45, Variable overhead $0.36, Fixed overhead $0.51, Total unit cost $2.19.

Plato Plastics has approached Thermal and offered to produce the 120,000 lids Thermal will require for current production levels of the T6 carrier, at a unit price of $1.75 each. Is this a good deal? Should Thermal buy the lids from Plato rather than produce them themselves? Initially, the $1.75 presented by Plato seems like a much better price than the $2.19 that it would cost Thermal to produce the lids. However, more information about the relevant costs is necessary to determine whether the offer by Plato is the better offer. Remember that all the variable costs of producing the lid will only exist if the lid is produced by Thermal, thus the variable costs (direct materials, direct labor, and variable overhead) are all relevant costs that will differ between the alternatives.

What about the fixed costs? Assume all the fixed costs are not tied directly to the production of the lid and therefore will still exist even if the lid is purchased externally from Plato. This means the fixed costs of $0.51 per unit are unavoidable and therefore are not relevant.

Calculations Using Sample Data

Calculations show that when the relevant costs are compared between the two alternatives, it is more cost effective for Thermal to produce the 120,000 units of the T6 lid internally than to purchase it from Plato.

Relevant costs to make internally: Direct materials $0.87, Direct labor $0.45, Variable overhead $0.36 equals Total unit relevant cost $1.68. Multiply times Units required 120,000 equals Total relevant costs $201,600. Relevant costs to buy from Plato: Total unit relevant cost $1.75 time Units required 120,000 equals $210,000.

By producing the T6 lid internally, Thermal can save $8,400 ($210,000 − $201,600). How would the analysis change if a portion of the fixed costs were avoidable? Suppose that, of the $0.51 in fixed costs per unit of the T6 lid, $0.12 of those fixed costs are associated with interest costs and insurance expenses and thus would be avoidable if the T6 lid is purchased externally rather than produced internally. How does that change the analysis?

Relevant costs to make internally: Direct materials $0.87, Direct labor $0.45, Variable overhead $0.36, avoidable fixed costs $0.12 equals Total unit relevant cost $1.80. Multiply times Units required 120,000 equals Total relevant costs $216,000. Relevant costs to buy from Plato: Total unit relevant cost $1.75 times Units required 120,000 equals $210,000.

In this scenario, it is more cost effective for Thermal to buy the T6 lid from Plato, as Thermal would save $6,000 ($216,000 − $210,000).

Final Analysis of the Decision

The difference in these two presentations of the data emphasizes the importance of defining which costs are relevant, as improper cost identification can lead to bad decisions.

These analyses only considered the quantitative factors in a make-versus-buy decision, but there are qualitative factors to consider as well, including:

  • Will the T6 lid made by Plato meet the quality requirements of Thermal?
  • Will Plato continue to produce the T6 lid at the $1.75 price, or is this a teaser rate to obtain the business, with the plan for the rate to go up in the future?
  • Can Plato continue to produce the quantity of the lids desired? If more or fewer are needed from Plato, is the adjusted production level obtainable, and does it affect the cost?
  • Does using Plato to produce the lids displace Thermal workers or hamper morale?
  • Does using Plato to produce the lids affect the reputation of Thermal?

In addition, if the decision is to buy the lid, Thermal is dependent on Plato for quality, timely delivery, and cost control. If Plato fails to deliver the lids on time, this can negatively affect Thermal’s production and sales. If the lids are of poor quality, returns, replacements, and the damage to Thermal’s reputation can be significant. Without long-term agreements on price increases, Plato can increase the price they charge Thermal, thus making the entire drink container more expensive and less profitable. However, buying the lid likely means that Thermal has excess production capacity that can now be applied to making other products. If Thermal chooses to make the lid, this consumes some of the productive capacity and may affect the relationship Thermal has with the outside supplier if that supplier is already working with Thermal on other products.

Make versus buy, one of many outsourcing decisions, should involve assessing all relevant costs in conjunction with the qualitative issues that affect the decision or arise because of the choice. Although it may appear that these types of outsourcing decisions are difficult to resolve, companies throughout the world make these decisions daily as part of the company’s strategic plan, and therefore, each company must weigh the advantages and disadvantages of outsourcing production of goods and services. Some examples are shown in Table 10.2.

Advantages and Disadvantages of Outsourcing
Advantages of Outsourcing Disadvantages of Outsourcing
  • Utilizes external expertise, removes the need for in-house expertise
  • Frees up capacity for other uses
  • Frees up capital for other uses
  • Allows management to focus on competitive strengths
  • Transfers some production and technological risks to supplier
  • Takes away control over quality and timing of production
  • May limit ability to upsize or downsize production
  • May have hidden costs and/or a lack of stability of price
  • May diminish innovation
  • Often makes it difficult to bring the production back in-house once it has been removed
Table 10.2

In an outsourcing decision, the relevant costs and qualitative issues should be analyzed thoroughly. If there are no qualitative issues that affect the decision and the leasing or purchasing price is less than the relevant (avoidable) costs of producing the good or service in house, the company should outsource the product or service. The following example demonstrates this issue for a service entity.

Lake Law has ten lawyers on staff who handle workers’ compensation and workplace discrimination lawsuits. Lake has an excellent success rate and frequently wins large settlements for their clients. Because of the size of their settlements, many clients are interested in establishing trusts to manage the investing and distribution of the funds. Lake Law does not have a trust or estate lawyer on staff and is debating between hiring one or using an attorney at a nearby law firm that specializes in wills, trusts, and estates to handle the trusts of Lake’s clients. Hiring a new attorney would require $120,000 in salary for the attorney, an additional 20% in benefits, a legal assistant for the new attorney for 20 hours per week at a cost of $20 per hour, and conversion of a storage room into an office. Lake spent $100,000 on redecorating the offices last year and has sufficient furniture for a new office. The attorney at the nearby firm would charge a retainer of $50,000 plus $200 per hour worked on each trust. The retainer is in addition to the $200 per hour charge for work on trusts. The average trust takes 10 hours to complete and Lake estimates approximately 50 trusts per year. In addition, an external attorney would charge $500 for each trust to cover office expenses and filing fees. Which option should Lake choose?

To determine the solution, first, find the relevant costs for hiring internally and for using an external attorney.

Hire internally: Salary $120,000, Benefits (20 percent) $24,000, Legal assistant (20 hrs times $20) $400 equals Total relevant costs $164,800. Use external attorney: Retainer $50,000, Cost per trust times number of trusts ($200 times 10 times 50) $100,000, Additional fees $500 equals Total relevant costs $175,000.

Based on the quantitative analysis, Lake should hire an estate attorney to have on staff. For the year, the firm would save $10,200 ($164,800 for internal versus $175,000 with the external attorney) by going with the internal hire. Other potential advantages would be that an in-house attorney could complete more than the estimated 50 trusts without incurring additional costs, and by keeping the work in-house, it helps to build the relationship between the firm and the clients. A disadvantage would be if there is not sufficient work to keep the in-house attorney busy, the company would still have to pay the $120,000 salary plus the additional costs of $44,800 for benefits and the legal assistant’s salary, even if the attorney is working at less than full capacity.

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