Questions For Make Or Buy u46i

Businesses produce revenue through selling their products to customers. Businesses can acquire these products through two methods--either producing them in-house or purchasing them from manufacturers. Choosing between these two methods is called the make-or-buy decision, or the outsourcing decision. Factors that influence the make-or-buy decision include both quantitative factors such as cost and time and qualitative factors such as the suppliers' trustworthiness and the quality of their products. In these decisions, as with all other decisions, the only costs that need to be considered are the relevant costs. These relevant costs are the costs that are different between the two options and usually consist of the variable costs and avoidable fixed costs. Fixed costs that will simply be transferred to another department—as allocated costs would be—are not avoidable, because the company as a whole will still incur those costs in total. These unavoidable costs are therefore irrelevant to the decision making process. Sunk costs are also ignored. Because they are historical costs that cannot be changed, they will be the same for every option the company has. Management must compare the relevant costs for each option (the costs that would be incurred only if a particular option is chosen), and then choose the option with the lowest incremental costs. If the cost to purchase the product from outside is lower than the avoidable costs of producing the item internally, the company should buy the product from the outside supplier. Businesses should first conduct an analysis of quantitative factors before factoring in qualitative factors to complete their make-or-buy decisions.

HOW TO ARRIVE AT A MAKE OR BUY DECISION? 1. Perform the quantitative analysis by comparing the costs incurred in each

option. The cost of purchasing products from suppliers is the price paid to purchase them. In contrast, the cost of production includes both fixed costs and variable costs. For example: a business needs 10 units of its product in 10 consecutive periods; it can either purchase the units at $100 per unit or spend $1,000 to set up production facilities and $8 to produce each unit. Since the business spends $10,000 (100x10x10) to purchase the products and $9,000 (1000+10x10x8) to produce the same number of products, it is better for the business to produce the products based on quantitative factors alone. 2. Consider qualitative factors that can influence the decision to produce the products. This includes all relevant factors that cannot be reduced to numbers, such as the experience of the business' production department and the quality of its management. For example, it might be possible that the business has no experience in producing a particular product and its prior experience in producing other products cannot be applied. 3. Consider qualitative factors that can influence the decision to purchase the products from outside suppliers. Examples of such factors include the suppliers' trustworthiness, the quality of its management, and the quality of its products. For 1

example, it might be possible that the business' supplier has extensive experience in producing the product being considered and that the business wants to cultivate a long-term relationship with its supplier. . 4. Factor the qualitative factors into the quantitative analysis in order to complete it. For example, in above case, although it is cheaper for the business to produce its products, there are reasons to believe that its products will be lower quality than those that it can purchase. Furthermore, since the business wants to cultivate a long-term relationship with its supplier, it might want to purchase its products from that supplier in order to initiate the relationship. 5.

Come to a final make-or-buy decision once both quantitative and qualitative factors have been considered; this will depend on the business in question and what it is doing in order to earn its profits. Continuing to use the above example, although the business likely can purchase higher-quality products than what it can produce, the quality of its products might not influence its sales depending on its business model and what it is selling. If this is the case, the desire to cultivate a long-term relationship may or may not be enough to outweigh the $1,000 savings in costs; it depends on how badly the business wants the relationship and what it can hope to achieve by initiating it.

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Make-or-buy decisions: non-financial considerations In reality, however, managers are likely to think about non-financial issues as well as financial issues when making their decisions. The non-financial considerations in any decision will depend on the circumstances, and will vary from one decision to another. Non-financial considerations can influence a decision Non-financial considerations that will often be relevant to a make-or-buy decision include the following.  When work is outsourced, the entity loses some control over the work. It will rely on the external supplier to produce and supply the outsourced items. There may be some risk that the external supplier will:  produce the outsourced items to a lower standard of quality, or  fail to meet delivery dates on schedule, so that production of the end-product may be held up by a lack of components.  The entity will also lose some flexibility. If it needs to increase or reduce supply of the outsourced item at short notice, it may be unable to do so because of the of the agreement with the external supplier. For example, the of the agreement may provide for the supply of a fixed quantity of the outsourced item each month.  A decision to outsource work may have implications for employment within the entity, and it may be necessary to make some employees redundant. This will have cost implications, and could also adversely affect relations between management and other employees.  It might be appropriate to think about the longer-term consequences of a decision to outsource work. What might happen if the entity changes its mind at some time in the future and decides either (a) to bring the work back in-house or (b) to give the work to a different external supplier? The problem might be that taking the work from the initial external provider and placing it somewhere else might not be easy in practice, since the external supplier might not be co-operative in helping with the removal of its work. The non-financial factors listed above are all reasons against outsourcing work. There might also be non-financial benefits from outsourcing work to an external supplier.  If the work that is outsourced is not specialised, or is outside the entity’s main area of expertise, outsourcing work will enable management to focus their efforts on those aspects of operations that the entity does best. For example, it could be argued that activities such as the management of an entity’s fleet of delivery vehicles, or the monthly payroll work, should be outsourced because the entity itself has no special expertise on these areas.  The external supplier, on the other hand, may have specialist expertise which enables it to provide the outsourced products or services more efficiently and effectively. For example a company might outsource all its IT operations, because it cannot recruit and retain IT specialists. An external service provider, on the other hand, will employ IT specialists.

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Summary of considered

Qualitative

Factors

to

Factors favouring in-house manufacture            

Wish to integrate plant operations Need for direct control over manufacturing and/or quality Cost considerations (costs less to make the part) Improved quality control No competent suppliers and/or unreliable suppliers Quantity too little to interest a supplier Design secrecy is necessary to protect proprietary technology Control of transportation, lead time, and warehousing expenses Political, environmental, or social reasons Productive utilization of excess plant capacity to assist with absorbing fixed overhead (utilizing existing idle capacity) Wish to keep up a stable workforce (in times when there are declining sales) Greater guarantee of continual supply

Factors favouring purchase from outside      

Suppliers’ specialized know-how and research are more than that of the buyer Lack of expertise Small-volume needs Cost aspects (costs less to purchase the item) Wish to sustain a multiple source policy Item not necessary to the firm’s strategy 4

be

  

Limited facilities for a manufacture or inadequate capacity Brand preference Inventory and procurement considerations

Costs for the make analysis        

Direct labor expenses Incremental inventory-carrying expenses Incremental capital expenses Incremental purchasing expenses Incremental factory operating expenses Incremental managerial expenses Delivered purchased material expenses Any follow-on expenses resulting from quality and associated problems

Cost factors for the buy analysis     

Transportation expenses Purchase price of the part Incremental purchasing expenses Receiving and inspection expenses Any follow-on expenses associated with service or quality

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Important Terminology: Variable Cost: Variable costs are those costs that are incurred only if the company actually produces something. If the company produces no units (sits idle for the entire period) no variable cost will be incurred by the company. Direct material and direct labour are usually variable costs. As the total production level increases the total amount of variable cost will increase but the variable cost per unit will remain same/ unchanged. Total Variable Cost ÷ Units Produced Variable Cost per Unit

$10,000 5,000 $2.00

$20,000 10,000 $2.00

$30,000 15,000 $2.00

Fixed costs: Fixed Costs are costs that do not change in total as the level of production changes, as long as production remains within the relevant range. The relevant range is the range of production in which the fixed cost is unchanged. As long as production activity remains within the relevant range, an increase in the number of units produced will not cause an increase in the total fixed costs. Fixed costs are best described by looking at a factory as an example. A factory has the capacity to produce a certain maximum number of units. As long as production is between 0 and that maximum number of units, the fixed cost for the factory will remain unchanged. However, once the level of production exceeds the capacity of the factory, the company will need to build (or otherwise acquire) a second factory. Building the second factory will increase the fixed costs as the company moves to another relevant range. Within the relevant range of production the total fixed costs will remain unchanged, but the fixed costs per unit will decrease as the level of production increases. Total Fixed Cost ÷ Units Produced

$30,000 5,000

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$30,000 10,000

$30,000 15,000

Fixed Cost per Unit

$6.00

$3.00

$2.00

Mixed Costs: Mixed costs or semi-variable costs have properties of both fixed and variable costs due to presence of both variable and fixed components in them. An example of mixed cost is telephone expense because it usually consists of a fixed component such as line rent and fixed subscription charges as well as variable cost charged per minute cost. Another example of mixed cost is delivery cost which has a fixed component of depreciation cost of trucks and a variable component of fuel expense. Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed and variable components by using cost behavior analysis techniques such as High-Low Method, Scatter Diagram Method and Regression Analysis. Relevant Costs and Irrelevant Costs When making the make-or-buy decision, it is necessary to distinguish between relevant and irrelevant costs. Relevant cost for making the product are all the costs that could be avoided by not making the product as well as the opportunity cost incurred by using the production facilities to make the product as opposed to the next best alternative usage of the production facilities. Relevant costs for purchasing the product are all the costs associated with buying it from suppliers. Irrelevant costs are the costs that will be incurred regardless of whether the product is manufactured internally or purchased externally. Types of Relevant Costs

Types of Non-Relevant Costs

Future Cash Flows

Sunk Cost

Cash expense that will be incurred in the Sunk cost is expenditure which has already future as a result of a decision is a relevant been incurred in the past. Sunk cost is cost. irrelevant because it does not affect the future cash flows of a business. Example: A company must decide whether to launch a new product on to the market. It has spent Rs.900,000 on developing the 7

new product, and a further Rs.80,000 on market research. A financial evaluation for a decision whether or not to launch the new product should ignore the development costs and the market research costs, because the Rs.980,000 has already been spent. The costs are sunk costs. Avoidable Costs The costs which are immune to a decision in the sense that they are incurred regardless a product or activity is continued or dropped. Example: A company has one year remaining on a short-term lease agreement on a warehouse. The rental cost is Rs.100,000 per year. The warehouse facilities are no longer required, because operations have been moved to another warehouse that has spare capacity. If a decision is taken to close down the warehouse, the company would be committed to paying the rental cost up to the end of the term of the lease. However, it would save local taxes of Rs.16,000 for the year, and it would no longer need to hire the services of a security company to look after the empty building, which currently costs Rs.40,000 each year. The decision about whether to close down the unwanted warehouse should be based on relevant costs only. Local taxes and the costs of the security services (Rs.56,000 in total for the next year) could be avoided and so these are relevant costs. The rental cost of the warehouse cannot be avoided, and so should be ignored in the economic assessment of the decision whether to close the warehouse or keep it open for another year.

Avoidable Costs

Only those costs are relevant to a decision that can be avoided if the decision is not implemented. Example: A company has one year remaining on a short-term lease agreement on a warehouse. The rental cost is Rs.100,000 per year. The warehouse facilities are no longer required, because operations have been moved to another warehouse that has spare capacity. If a decision is taken to close down the warehouse, the company would be committed to paying the rental cost up to the end of the term of the lease. However, it would save local taxes of Rs.16,000 for the year, and it would no longer need to hire the services of a security company to look after the empty building, which currently costs Rs.40,000 each year. The decision about whether to close down the unwanted warehouse should be based on relevant costs only. Local taxes and the costs of the security services (Rs.56,000 in total for the next year) could be avoided and so these are relevant costs. The rental cost of the warehouse cannot be avoided, and so should be ignored in the economic assessment of the decision whether to close the warehouse or keep it open for another year. Opportunity Costs Non-Cash Expenses Cash inflow that will be sacrificed as a result of a particular management decision is a relevant cost. Example: A company has been asked by a customer to carry out a special job. The work would require 20 hours of skilled labour time. There is a limited availability of skilled labour, and

Non-cash expenses such as depreciation are not relevant because they do not affect the cash flows of a business. Example: Non-cash items, such as depreciation and amortization, are frequently categorized as irrelevant costs for most types of management decisions, since they do not 8

if the special job is carried out for the impact cash flows. customer, skilled employees would have to be moved from doing other work that earns a contribution of Rs.60 per labour hour. A relevant cost of doing the job for the customer is the contribution that would be lost by switching employees from other work. This contribution forgone (20 hours × Rs.60 = Rs.1,200) would be an opportunity cost. This cost should be taken into consideration as a cost that would be incurred as a direct consequence of a decision to do the special job for the customer. In other words, the opportunity cost is a relevant cost in deciding how to respond to the customer’s request. Incremental Cost General Overheads Where different alternatives are being considered, relevant cost is the incremental or differential cost between the various alternatives being considered. Example A company has identified that each cost unit it produces has the following costs: Rs. in ‘000 Direct materials 50 Direct labour 20 70 Fixed production overhead 30 Total absorption cost 100 The incremental cost of making one extra unit is Rs. 70,000. Making one extra unit would not affect the fixed cost base. Differential cost A differential cost is the amount by which future costs will be different, depending on which course of action is taken. A differential cost is therefore an amount by which future costs will be higher or lower, if a particular course of action is chosen. Provided that this additional cost is a cash flow, a differential cost is a relevant cost. Example: A company needs to hire a photocopier for the next six months. It has to decide whether to continue using a particular type of photocopier, which it currently rents for Rs.2,000 each month, or whether to switch to using a larger photocopier that will cost

General and istrative overheads which are not affected by the decisions under consideration should be ignored.

Committed Costs Future costs that cannot be avoided are not relevant because they will be incurred irrespective of the business decision bieng considered. Example: A company bought a machine one year ago and entered into a maintenance contract for Rs. 20,000 for three years. The machine is being used to make an item for sale. Sales of this item are disappointing and are only generating Rs, 15,000 per annum and will remain at this level for two years. The company believes that it could sell the 9

Rs.3,600 each month. If it hires the larger photocopier, it will be able to terminate the rental agreement for the current copier immediately. The decision is whether to continue with using the current photocopier, or to switch to the larger copier. One way of analysing the comparative costs is to say that the larger copier will be more expensive to rent, by Rs.1,600 each month for six months. The differential cost of hiring the larger copier for six months would therefore be Rs.9,600 (1600x6).

machine for Rs. 25,000. The relevant costs in this decision are the selling price of the machine and the revenue from sales of the item. If the company sold the machine it would receive Rs. 25,000 but lose Rs. 30,000 revenue over the next two years – an overall loss of Rs. 5,000 The maintenance contract is irrelevant as the company has to pay Rs. 20,000 per annum whether it keeps the machine or sells it. Leases normally represent a committed cost for the full term of the lease, since it is extremely difficult to terminate a lease agreement.

Example for Relevant & Non-relevant Costs: Butt Industries is a company that manufactures personal care products. It has three divisions: hair care, skin care and dental care. Following is an extract from the financial statements for the year ending 31 December 2016:

Hair Care

Skin Care

Dental Care

Revenue

$900 million $600 million $300 million

Net income/(loss)

$210 million $100 million ($50 million)

In the board meeting summoned for review of financial statements, a director proposed that the company should dispose of the dental care division because it is losing money. The CEO argued that the board can’t conclude that a segment is losing money just because it generated net loss for a period. He suggested that the company’s chief financial officer should conduct a detailed analysis for presentation in the next board meeting. Being the company’s management ant, the CFO asked you to identify which of the following costs are relevant for the decision: 1. 2. 3. 4. 5. 6. 7. 8. 9.

CEO’s salary Salaries of Dental Care workers who can be laid-off Salaries of Dental Care workers who can’t be laid-off One-time retirement benefits to be paid to laid-off workers Cost of raw materials consumed by Dental Care division Annual directors’ fee Interest paid on loans raised for Dental Care division Salary of the Dental Care chief operating officer Company-wide quality certification fee 10

10. License fee paid for the rights to manufacture dental care products 11. Head office rent 12. Audit fee (if it doesn’t depends on the number of divisions)

Solution: We have two alternatives: (a) dental care division is sold off and (b) dental care division continues to operate. Identifying relevant costs and irrelevant costs is easy when we see if a cost changes between two alternatives or not. If it changes it is relevant, if it doesn’t it is irrelevant. 1. CEO’s salary is irrelevant because it shall remain the same whether the dental care

division exists or it is disposed off. 2. Salaries of employees who can be laid off is relevant because the cost shall continue

to be incurred if the division exists but it shall be reduced to zero if the division is disposed off. 3. Salaries of employees who can’t be laid-off is irrelevant because it shall continue to be incurred regardless of whether the division is disposed off or not. 4. One-time retirement benefits cost is relevant because it shall be incurred only if the division is disposed off. If the division continues to operate, the cost shall continue to be incurred. 5. Cost of raw materials is relevant cost because it shall be zero if the division no longer operates because then there will be no production. 6. Annual directors fee is irrelevant cost because it shall stay the same even if dental care is disposed off. 7. Interest paid on dental care division loans is relevant because if the division is sold off the loan could be paid off which shall cease the interest cost. 8. Salary of the dental care chief operating officer is relevant because he will most likely lose his job. If he is accommodated in another division, this cost shall be irrelevant. 9. Company-wide quality certification fee is irrelevant because it shall continue to be incurred even if dental care division is no longer there. 10. License fee paid for manufacturing dental care products is a relevant cost because it shall cease with disposal of the division. 11. Head office rent is irrelevant because it shall remain the same regardless of the number of divisions. If a division is sold-off, head-office will still exist and the office rent shall be incurred. 12. Audit fee is irrelevant if it does not depend on the number of divisions. Audit shall be conducted even if there is one division less. Note: A problem may state that some of the variable costs are not avoidable mean non relevant (explanation given below), meaning that they will still be incurred, even if the product is purchased. The unavoidable variable costs should not be treated as relevant costs since they are unavoidable. On the other hand, a problem may state that some of the fixed costs are avoidable if the company outsources the manufacturing. The avoidable 11

fixed costs should be treated as relevant costs because they are avoidable. Non-Relevant Variable Costs: There might be occasions when a variable cost is in fact a sunk cost (and therefore a non-relevant variable cost). For example, suppose that a company has some units of raw material in stock. They have been paid for already, and originally cost Rs. 2,000. They are now obsolete and are no longer used in regular production, and they have no scrap value. However, they could be used in a special job which the company is trying to decide whether to undertake. The special job is a Rs.non-off' customer order, and would use up all these materials in stock. a. In deciding whether the job should be undertaken, the relevant cost of the materials to the special job is nil. Their original cost of Rs. 2,000 is a sunk cost, and should be ignored in the decision. b. However, if the materials did have scrap value of, say, Rs. 300, then their relevant cost to the job would be the opportunity cost of being unable to sell them for scrap, i.e. Rs. 300 Note: When determining relevant costs for such types of decisions, the following must be

kept in mind: • The purchasing costs (purchase price, ordering costs, transportation costs, carrying costs, etc.) relating to the purchase from an outsider are all relevant variable costs and must be included in the cost of purchasing the item. • Only avoidable fixed and variable costs of in-house production are relevant and need to be included in the cost of producing the item internally. You must be able to determine the maximum price that the company will be willing to pay an outside supplier for a product that they currently make. This price is the amount of internal production costs that will not be incurred (that will be avoided) by purchasing the product from outside. Usually, the maximum price that a company would be willing to pay for purchasing outside the company is: Maximum Price to Pay = Total Internal Production Costs – Unavoidable Costs (Fixed and Variable)

Q No.01: Medina Co. produces football goal posts for sale to college and professional football teams. The variable and fixed costs to produce a goal post are as follows: Direct materials $ 200 Direct labor 150 Indirect variable costs 75 Fixed costs 125 Selling and istrative costs 100 Total $650 Bowden Corp. has recently approached Medina with an offer to supply Medina with finished goal posts that Medina would then resell under the Medina name. The price of one goal post from Bowden is $490. If Medina purchased goal posts from Bowden, all of its fixed costs would continue to be incurred, but Medina would be able to eliminate half of the selling and istrative costs that are associated with the production and sale of their own goal posts. The other variable costs would not be incurred because they would not need to pay any production costs if they purchase goal posts from an outside supplier.

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Should Medina accept Bowden’s offer, and if not, at what price would Medina be willing to accept the offer? Solution:

Medina should not accept the offer from Bowden. If they accept the offer, their total costs incurred would be $665 per goal post. Goal post purchase price $490 Fixed costs that would continue 125 Selling and . costs that would continue 50 Total cost $665 What is the maximum price Medina would be willing to pay Bowden? Given that Medina will have $175 per post of internal costs that will continue even if they purchase from Bowden, the maximum price that they would be willing to pay is $175 less than their cost of production, or $475 per post. Other Considerations Even if Bowden’s offer had been acceptable from a quantitative standpoint, Medina would need to determine if it is acceptable from a qualitative standpoint. Medina is going to put its own name on these goal posts and therefore, before accepting any offer to let another company do the manufacturing, they would need to evaluate other things such as the quality of Bowden’s manufacturing processes, reliability of delivery, and availability of service if necessary.

Questions with suggested solutions Q No.02: The estimated costs of producing 6,000 units of a component are: Direct Material Direct Labor Applied Variable Factory Overhead Applied Fixed Factory Overhead $1.5 per direct labor dollar

Per Unit $10 8 9 12

Total $60,000 48,000 54,000 72,000

$39

$234,000

The same component can be purchased from market at a price of $29 per unit. If the component is purchased from market, 25% of the fixed factory overhead will be saved. Should the component be purchased from the market? Solution

Purchase Price Direct Material Direct Labor

Per Unit Make Buy $29 $10 8 13

Total Make $60,000 48,000

Buy $174,000

Variable Overhead Relevant Fixed Overhead Total Relevant Costs Difference in Favor of Buying

9 3 $30

$29 $1

54,000 18,000 $180,000

$174,000 $6,000

XYZ Ltd. has an annual production of 90,000 units for a motor component. The component cost structure is as below: Particulars

Amount (Rs.)

Material

270 per unit

Labour (25% Fixed)

180 per unit

Expenses: Variable

90 per unit

Fixed

135 per unit

Total

675 per unit

Required: (a) The purchase manager has an offer from a supplier who is willing to supply the component at Rs.540. Should the component be purchased and production stopped? (b) Assume the resources now used for this component’s manufacture are to be used to produce another new product for which the selling price is Rs. 485. In the latter case the material price will be Rs. 200 per unit. 90,000 units of this product can be produced at the same cost basis as above for labour and expenses. Discuss whether it would be advisable to divert the resources to manufacture that new product, on the footing that the component presently being produced, be purchased from the market. Solution: (a) Manufacture

Statement of Comparative Cost per unit Amount (Rs.)

Cost to be incurred due to manufacture Material Labour Variable overhead Relevant cost

Purchase Purchase cost

270 135 90 495

Amount (Rs.) 540

540

It’s better to produce a component in house because the relevant cost of manufacturing the component in house is less than the purchase cost. Further, we can say that unavoidable fixed cost = (45 + 135) × 90,000 (Deptt. Share) = 1,62,00,000.

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(b)

Statement of Comparative Cost

Manufacture

Amount (Rs.)

Cost to be incurred (from Part-a)

495

Benefit to be lost due to manufacturing (WN:1)

60

Relevant cost

555

Amount (Rs.)

Purchase Purchase cost

540

540

Hence, It’s better to purchase the component from outside market, Working Note 1 Calculation of Benefit to be lost If the component is to be purchased from the market, then the release capacity would provide the benefit of Rs. 60 per unit as follows: Particulars

Rs.

Selling price

-

485

Less: variable cost: Material

-

Labour

200 135

Variable-overheads

-

Benefit lost

90

425 60

Q No.03: SS Ltd. is producing a part at a cost of Rs. 11 per unit. The composition of the cost is as follows: (Rs.) Materials 3.00 Wages 4.00 Overheads–Variable 2.50 - Fixed 1.50 11.00 Presently, the firm has been incurring a total fixed cost of Rs. 15,000 for manufacturing the current production of 10,000 units. An outsider is offering the same component, in all aspects identical in features, for Rs. 10 per unit. On enquiry, it is found from the firm that the machine

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that is manufacturing the parts would remain idle as the machinery cannot be utilized elsewhere. (A) Should the offer be accepted? (B) Would your answer would be different, if the outside firm reduces the price to Rs. 9, after negotiation. What is the impact of the fixed costs in the decision-making process? Solution: The variable cost of the product is as under: (Rs.) 3.00 4.00 2.50 9.50

Materials Wages Overheads–Variable Total Variable Cost

(A) Here, the additional costs (variable costs) for making are Rs. 9.50. The outside market price is Rs. 10. The outside offer is on a higher side by Rs. 0.50 per unit, so the offer is to be rejected. For every unit bought outside, it results in a loss of Rs. 0.50 per unit. (B) Now, the outside firm is willing to reduce the price to Rs. 9, while the variable cost is Rs. 9.50. The offer is to be accepted. So far as the fixed costs Rs. 15,000 is concerned, the firm would incur, whether the firm makes the product itself or buys it outside. In other words, the existing fixed costs are not to be considered, while taking a decision.

Q No.04: A firm needs component in an assembly operation. If it wants to do the manufacturing itself, it would need to buy a machine for Rs. 400,000 which will last for 4 years with no salvage value. Manufacturing costs in each of the 4 years would be Rs. 600,000, Rs. 700,000, Rs. 800,000 , and Rs. 1 million respectively. If the firm had to buy the components from a supplier, the cost would be Rs. 0.9 million, Rs. 1 million, Rs. 1.1 million and Rs. 1.4 million respectively in each of the four years. However, the machine would occupy floor space which would have been used for another machine. This latter machine would be hired at no cost to manufacture an item, the sale of which would produce net cash flows in each of the four years of Rs. 0.2 million. It is impossible to find room for both the machines and there are no other external effects. The cost of capital is 10% and the present value factor for each of the four years is 0.909, 0.826, 0.751 and 0.683 respectively. Should the firm make the components or buy from outside?

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Solution Evaluation of Make or Buy proposal (All figures are in 00,000 of rupees) Year

(a) 0 1 2 3 4 Total

P.V. factors at 10%

(b) 1.000 0.909 0.826 0.751 0.683

When the component is manufactured Cash outflow (Rs.) (c) 4 8 9 10 12

Present value (Rs.) (d) = (b) × (c) 4.000 7.272 7.434 7.510 8.196 34.412

When the component is bought from an outside supplier Cash outflow Present value (Buying cost) (Rs.) (Rs.) (e) (f) = (b) × (e) — — 9 8.181 10 8.260 11 8.261 14 9.562 34.264

* (Capital cost + manufacturing cost + opportunity cost)

= Rs. 34.412 – Rs. 34.264 = Rs. 0.148 (lakhs) Conclusion: Since there is a saving of Rs. 0.148 (lakhs) in buying the component from outside, therefore, we should stick to this decision.

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Q No. 05: X is a multiple product manufacturer. One product line consists of motors and the company produces three different models. X is currently considering a proposal from a supplier who wants to sell the company blades for the motors line.

The company currently produces all the blades it requires. In order to meet customer's needs, X currently produces three different blades for each motor model (nine different blades). The supplier would charge Rs. 25 per blade, regardless of blade type. For the next year X has projected the costs of its own blade production as follows (based on projected volume of 10,000 units): Direct materials…………………………………………..……………...Rs. 75,000 Direct labour……………………………………………….……………Rs. 65,000 Variable overhead…………………………………………………….….Rs. 55,000 Fixed overhead Factory supervision………………………………………………………... Rs. 35,000 Other fixed cost…………………………………...………………….…

Rs. 65,000

Total production costs………………………..……………………..….Rs. 2,95,000 Assume (1) the equipment utilized to produce the blades has no alternative use and no market value, (2) the space occupied by blade production will remain idle if the company purchases rather than makes the blades, and (3) factory supervision costs reflect the salary of a production supervisor who would be dismissed from the firm if blade production ceased. Required (i) Determine the net profit or loss of purchasing (rather than manufacturing), the blades required for motor production in the next year. (ii) Determine the level of motor production where X would be indifferent between buying and producing the blades. If the future volume level were predicted to decrease, would that influence the decision? (iii) For this part only, assume that the space presently occupied by blade production could be leased to another firm for Rs. 45,000 per year. How would this affect the make or buy decision?

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Solution: (i) This is a make or buy decision so compare the incremental cost to make with the incremental cost buy Incremental Costs Per Unit (Rs.) 7.50 6.50 5.50 3.50 23.00

Direct Materials (Rs.75,000 ÷ 10,000 units) Direct Labour (Rs.65,000 ÷ 10,000 units) Variable Overhead (Rs.55,000 ÷ 10,000 units) Supervision (Rs.35,000 ÷ 10,000 units) Total Cost

Compare the cost to make the blades for 10,000 motors. Rs.23.00, with the cost to buy, Rs. 25.00 There is a net loss of Rs.2.00 if ‘X’ chooses to buy the blades. (ii) ‘X’ will be indifferent between buying and making the blades when the total costs for making and buying will be equal at the volume level where: Variable Cost per unit × No. of units + Avoidable Fixed Cost = Cost of Buy Variable Cost per unit (DM + DL + VO) × No. of units + Factory Supervision Cost = Buying Cost per unit × No. of units Let No. of in units

=U

(Rs.7.50 + Rs.6.50 + Rs.5.50) × U + Rs.35,000

=

Rs.25.00 U

Rs.19.50 U + Rs.35,000

=

Rs.25.00 U

Rs.25.00 U – Rs.19.50 U

=

Rs.35,000

Rs.5.50 U U

=

=

Rs.35,000

6,364 units of blades

As volume of production decreases, the average per unit cost of in house production increases. If the volume falls below 6,364 motors, then ‘X’ would prefer to buy the blades from the supplier. (iii) If the space presently occupied by blade production could be leased to another firm for Rs.45,000 per year, ‘X’ would face an opportunity cost associated with in house blade production for the 10,000 units of Rs.4.50 (45,000/10000) per unit. New Cost to Make = Rs.23.00 + Rs.4.50 = Rs.27.50 Now ‘X’ should buy because the cost to make, Rs.27.50, is higher than the cost to buy, Rs. 25. 19

Q No. 06: Golden Bird Ltd. produces and sells Bicycles. It also manufactures the chains for its Bicycles. It expects to produce and sell 24,000 Bicycles during 2014 –15. It is considering an offer from an outside vendor to supply any number of chains at Rs. 12 per chains. The ant of Golden Bird Ltd. reports the following costs for producing 24,000 chains: Particulars

Direct material Direct labour Variable manufacturing overhead Inspection, set up etc. Machine rent Allocated fixed overhead Total

Cost per unit (Rs.) 5.00 4.00 2.00 1.00 1.00 1.25 14.25

Total Cost (Rs.) 1,20,000 96,000 48,000 24,000 24,000 30,000 3,42,000

The following additional information is available: (a)

Inspection, set up etc. vary with the number of batches in which the chains are produced. Currently chains are being produced in the batch size of 2,000 units.

(b)

Direct labour cost represents wages to four workers who are exclusively engaged in the manufacturing of chains. These workers are in permanent capacity and cannot be retrenched.

(c)

if Golden Bird Ltd. procures all its chains from outside vendor it will not require the machine which it has hired for manufacturing chains.

Required (i) Assume that if Golden Bird Ltd. purchase chains from outside vendor, the facility (including workers) where the chains are currently manufactured will remain idle. Should Golden Bird Ltd. accept the offer from outside vendor at the anticipated production and sale volume of 24,000 units. (ii) Whether your decision in (i) will change if facilities can be used to upgrade the Bicycle which will result in an incremental revenue of Rs. 22 per Bicycle. The variable cost for upgrading would be Rs. 18 and tooling cost would be Rs. 16,000. (iii) Assume that facilities will be used as stated in (ii) above. Further, assume that with better planning Golden Bird Ltd. will be able to manufacture chains in the batch size of 4,000 units (instead of 2,000 units) if it decides to produce chains inside.

20

Solution (i) Deciding whether Golden Bird Ltd. should accept the offer from an outside vendor instead of manufacturing the chains inside. (Rs.) Offered Bought Out Price per chain (if Purchased from Outside 12 Vendor) Less: Variable Cost per unit (if Chains were Produced inside) 7 Excess of Bought Out Price per chain over Variable Cost 5 Total Excess Amount if 24,000 Chains were Purchased 1,20,000 Less: Avoidable Costs Inspection Setup etc. 24,000 Machine Rent 24,000 Excess of Bought Out Price over Variable and Avoidable Cost 72,000

Golden Bird Ltd. should not accept the offer of an outside vendor because its acceptance would result in the reduction of profit by Rs. 72,000. (ii) Deciding whether the use of internal facilities for upgrading the quality of chains the quality of chains would be beneficial in comparison to their purchase from an outside vendor. (Rs.) Incremental Revenue per Bicycle 22 Less: Differential Cost per Bicycle 18 Contribution per Bicycle 4 Total Contribution (24,000 × Rs.4) 96,000 Less: Tooling Cost 16,000 Net Contribution 80,000 Golden Bird Ltd. should accept the offer of alternative use of facilities for upgrading the Bicycle as its use, would produce, an incremental net contribution of Rs.80,000, which is more than the excess of bought out price over variable and avoidable costs by Rs.8,000. (iii) Deciding whether the use of internal facilities for upgrading the Bicycle (Chain) internally would be profitable to the concern when the batch size becomes, 4,000 units in comparison to their purchases from an outside vendor. When the batch size increases to 4,000 units of chains the concern would be producing 6 batches of output and such an action would reduce the inspection set up cost by Rs.12,000. In this way there would be a saving of Rs.12,000 towards inspection and set up costs. Excess of Bought Out Price is Rs.84,000 (Rs.72,000 + Rs.12,000) [refer to (i)]. If Golden Bird Ltd. utilises internal facilities for producing / upgrading the quality of bicycle, then it would generate a net contribution of Rs. 80,000 [Refer to (ii)]. On

21

the other hand buying chains from outside would reduce concern’s profitability by Rs. 84,000. Hence the use of facilities for upgrading the quality of Bicycle (Chains) is advocated. Q No. 07:Jahan Ltd, a ‘Fast-Moving Consumer Goods (FMCG)’ company intends to diversify the product line to achieve full utilisation of its plant capacity. As a result of considerable research made, the company has been able to develop a new product called ‘EXE’. ‘EXE’ is packed in cans of 100 ml capacity and is sold to the wholesalers in cartons of 24 cans at Rs.120 per carton. Since the company uses its spare capacity for the manufacture of ‘EXE’, no additional fixed expenses will be incurred. However ant has allocated a share of Rs. 112,500 per month as fixed expenses to be absorbed by ‘EXE’ as a fair share of the company’s present fixed costs to the new product for costing purposes. The company estimates the production and sale of ‘EXE’ at 150,000 cans per month and on this basis the following cost estimates (per carton) have been developed: Rs. Direct Materials …………………………………….54 Direct Wages… ………………..……………. 36 All Overheads ………………………………… …27 Total Costs… ………………………………………….. 117 After a detailed market survey the economy is confident that the production and sales of ‘EXE’ can be increased to 175,000 cans per month and ultimately to 225,000 cans per month. The company at present has a capacity for the manufacture of 150,000 empty cans and the cost of the empty cans if purchased from outside will result in a saving of 20% in material and 10% in other costs of ‘EXE’. The price at which the outside firm is willing to supply the empty cans is Rs. 0.675 per empty can. If the company desires to manufacture empty cans in excess of 150,000 cans, a machine involving an additional fixed overhead of Rs. 7,500 per month will have to be installed.

Required (i) State by showing your workings whether the company should make or buy the empty cans at each of the three volumes of production of ‘EXE’ namely, 150,000, 175,000 and 225,000 cans. (ii) At what volume of sales will it be economical for the company to install the additional equipment for the manufacture of empty cans? (iii) Evaluate the profitability on the sale of ‘EXE’ at each of the aforesaid three levels of output based on your decision and showing the cost of empty cans as a separate element of cost.

Solution (i) If the company increases production to 175,000 cans of ‘EXE’, 150,000 empty cans should be manufactured and additional 25,000 cans should be purchased at Rs.16,875 [Refer W.N. 5 & 6] If the company increases production to 225,000 cans of ‘EXE’, 150,000 empty cans should be manufactured and additional 75,000 cans should be purchased at a cost of Rs. 50,625. [Refer W.N. 5 & 6] 22

(ii) Additional fixed overheads to be incurred on a new machine: Rs.7,500 Savings per unit if empty cans are made instead of buying: Rs. 0.675 – Rs. 0.6375 = Rs. 0.0375 Minimum additional quantity of empty cans to be made to recover the additional fixed costs: Rs.7,500/ Rs.0.0375 = 200,000 empty cans Installation of the new machine for the manufacture of empty cans will be economical at production level of 3,50,000 cans per month. (iii)

Evaluation of the Profitability on Sale of “EXE” at the 3 Levels.

Sales Less: Direct Material Direct Wages Variable Overheads Empty can made Empty can purchases Net Gain

Per 1,50,000 can can (R (Rs.) s.) 5.0000 7,50,000.0 0 1.8000 2,70,000.0 0 1.3500 2,02,500.0 0 0.3375 50,625.00

1,75,000 can (Rs.)

2,25,000 can (Rs.)

8,75,000.0 0 3,15,000.0 0 2,36,250.0 0 59,062.50

11,25,000 .00 4,05,000. 00 3,03,750. 00 75,937.5 0 95,625.0 0 50,625.0 0 1,94,062. 50

0.6375 95,625.00 95,625.00 0.6750

16,875.00 1,31,250.0 1,52,187.5 0 0

Workings (1)

All Overheads for one carton or 24cans Therefore, per can Overheads (Rs.27/24)

Rs.27 Rs. 1.125

Fixed Overheads Allocated for 150,000 cans Per can Fixed Overheads (Rs.1,12,500 / 1,50,000 cans)

Rs.112,500 Rs.0.75

Variable Overheads per can (Rs.1.125 – Rs.0.75) (2)

Direct Wage per carton Per can (Rs.36 / 24)

(3)

Direct Materials per carton

Rs.0.375 Rs.36 Rs.1.50 Rs. 54

Per can (Rs.54 / 24)

Rs.2.25

23

(4)

Cost of making one empty can:

Direct Material

Cost per can of ‘EXE’ (Rs.) 2.250

Direct Wages

1.500

Variable Overheads Total

0.375

Cost % empty can

Cost empty can (Rs.)

2 0 1 0 1 0

4.125

0.4500

Cost of per can of ‘EXE’ without empty can (Rs.) 1.8000

0.1500

1.3500

0.0375

0.3375

0.6375

3.4875

(5) Cost of manufacturing/buying of 150,000 empty cans of ‘EXE’:

Direct Material Direct Wages Variable Overheads Purchase Price Total

Empty can Cost (Rs.) 0.4500 0.1500 0.0375

If empty can made (Rs.)

0.6750

If empty can purchased (Rs.)

67,500.00 22,500.00 5,625.00

-------------

----95,625.00

101,250.00 101,250.00

Company should manufacture the empty cans for a production volume of 150,000 ‘EXE’ cans as capacity is available and cost of manufacture is lower. (6) After the level of 150,000 empty cans, the company has to install a new machine involving a total additional Fixed Overheads of Rs. 7,500. The cost of making and buying the additional cans of 25,000 and 75,000 will be as follows:

Direct Material Direct Wages Variable Overheads Additional

Buy (Rs.) Cost per Make (Rs.) can (Rs.) 25,000 cans 0.4500 11,250.00 ----0.1500 3,750.00 ----0.0375 937.50 ----7,500.00 ----24

Make Buy (Rs.) (Rs.) 75,000 cans 33,750.00 ----11,250.00 ----2,812.50 ----7,500.00 -----

Overheads Purchase Price Total

0.6750

---16,875.00 ----50,625.00 23,437.50 16,875.00 55,312.50 50,625.00

The cost of buying additional empty cans at both the levels is lower than the cost of their manufacture

25

Make-or-buy decisions with scarce resources/Key factor/Limiting Factor A different situation arises when an entity is operating at full capacity, and has the opportunity to outsource some production in order to overcome the restrictions on its output and sales. For example a company might have a restriction, at least in the shortterm, on machine capacity or on the availability of skilled labour. It can seek to overcome this problem by outsourcing some work to an external supplier who makes similar products and which has some spare machine time or labour capacity. In this type of situation, a relevant cost approach is to assume that the entity will: seek to maximise its profits, and therefore outsource some of the work, provided that profits will be increased as a consequence. The decision is about which items to outsource, and which to retain in-house. The profit-maximising decision is to outsource those items where the costs of outsourcing will be the least. To identify the least-cost outsourcing arrangement, it is necessary to compare: the additional costs of outsourcing production of an item with the amount of the scarce resource that would be needed to make the item in-house. Costs are minimised (and so profits are maximised) by outsourcing those items where the extra cost of outsourcing is the lowest per unit of scarce resource ‘saved’. A limiting factor is any factor that is in scarce supply and without that further activities cannot be performed i.e. it limits the organizations activity. Limiting factor or key factor is ‘Anything which limits the activity of an entity. An entity seeks to optimise the benefit it obtains from the limiting factor. Examples are a shortage of supply of a resource or a restriction on sales demand at a particular price’. Key factor may be anything i.e. materials, labour, machine time, sales quantity etc. Many times the management has to take a decision whether to produce one product or another instead. Generally decision is made on the basis of contribution of each product. Other things being the same the product which yields the highest contribution is best one to produce. But, if there is shortage or limited supply of certain other resources which may act as a key factor like for example, the machine hours, then the contribution is linked with such a key factor for taking a decision. For example, in an undertaking the availability of machine capacity is limited and the machine hours required for one unit of the two products are different. In such cases the contribution is to be linked with the machine hour and the product which yields the highest contribution per machine hour is to be preferred for taking decision.

Three steps in key factor analysis Step 1: - First determine the limiting factor (bottleneck resource) Step 2: - Rank the options using the contribution earned per unit of the scarce resource Step 3: - Allocate resources

26

Q No. 08: Agree caps Ltd., engaged in manufacturing agricultural machinery, is preparing its annual budget for the coming year. The company has a metal pressing capacity of 20,000 hours, which will be insufficient for manufacture of all requirements of components A, B, C and D. The company has the following choices(i)

Buy the components entirely from outside suppliers.

(ii)

Buy from outside suppliers and / or use a partial

second shift. The data for the current year are given belowStandard Production Cost per unit-

Requirement (in units) Variable Cost Direct Materials Direct Wages Direct Expenses Fixed Overhead Total Production Cost

A (Rs. ) 2,000 37 10 10 5 62

B (Rs. ) 3,500 27 8 20 4 59

C (Rs. ) 1,500 25 22 10 11 68

D (Rs. ) 2,800 44 40 60 20 164

Direct expenses relate to the use of the metal presses which cost Rs. 10 per hour, to operate. Fixed overheads are absorbed as a percentage of direct wages. Supply of all or any part of the total requirement can be obtained following prices, each delivered to the factoryComponent (Rs.) A ....................................................60 B ....................................................59 C… .............................................. 52 D… ............................................. 168 Second shift operations would increase direct wages by 25 percent over the normal shift and fixed overhead by Rs. 500 for each 1,000 (or part thereof) second shift hours worked. Required (i) Which component, and in what quantities should be manufactured in the 20,000 hours of press time available? (ii) Whether it would be profitable to make any of the balance of components required on a second shift basis instead of buying them from outside suppliers

27

Solution (i)

Components and Quantities to be Manufactured in 20,000 Hours of Press Time Available (Single Shift Operation)

Hrs. Available Capacity for Metal Pressing First, Produce D, Hours Required (2,800 ×6) Balance Hours Available Second, Produce A, Hours Required (2,000 × 1) Balance Hours Available Third, Produce B, for the Balance Hours Available (600 × 2) Balance Hours Available

20,000 16,800 3,200 2,000 1,200 1,200 Nil

So, in 20,000 hours of press time available, all the requirements of components D and A and only 600 units of B can be manufactured. The balance requirement of component B i.e. 2,900 (3,500 – 600) units will have to be bought out or manufactured in the second shift. (ii)

Since the purchase price of Component C (i.e. Rs. 52) is lower than the marginal cost of manufacturing (i.e. Rs. 57) in even single shift, it will not be profitable to make it, hence it should be purchased from outside. Now it is to be seen whether 2,900 units of B should be produced in the second shift or bought from outside. The comparative position is given below:

Cost of Producing 2,900 units of Component B in Second Shift

Variable Cost per unit on Single Shift Basis Add: Increase in Direct Wages per unit Variable Cost per unit Total Variable Cost for 2,900 units (2,900 units × Rs.57) Additional Fixed Cost* Total Cost for Producing 2,900 units of B in Second Shift Bought Out Price for 2,900 units of B (2,900 units × Rs.59) Disadvantage in Buying …(A) – (B)

…(A) …(B)

(Rs. ) 55.00 2.00 57.00 1,65,300 3,000 1,68,300 1,71,100 (2,800)

(*) Additional Fixed Cost 5,800 hrs (2,900 units x 2 hrs.) are required for 2,900 units of B. Extra Fixed Cost for 5,800 hrs at Rs. 500 for every 1,000 hours (or part thereof) is Rs.3,000. 28

Since the cost of manufacturing balance quantity of component B i.e. 2,900 units in second shift is less by Rs.2,800, it is profitable to make it on a second shift basis instead of buying from outside suppliers. Working Notes (a)

Process Hours Required

A B C D (Rs.) (Rs.) (Rs.) (Rs.) 10 20 10 60

Direct Expenses per unit (A) No. of Press Hours per unit (A/10) (Direct Expenses per press hour being Rs.10) (b)

1

2

1

6

Marginal Cost of Production per unit Vs Bought Out Price per unit

A B C D (Rs.) (Rs.) (Rs.) (Rs.) Marginal Cost Direct Material Direct Wages Direct Expenses Marginal Cost per unit Bought Out Price Excess of Bought Out Price over Marginal Cost Press Hours per unit Excess of Bought Out Price per unit of Limiting Factor (i.e. Press Hour) Ranking

37 10 10 57 60 3

27 8 20 55 59 4

25 22 10 57 52 (5)

44 40 60 144 168 24

1 3

2 2

1 (5)

6 4

2

3

1

The bought–out price for component C is lower by Rs.5 than the marginal cost of production and so it should be purchased from outside. In case the remaining components A, B, and D are bought, their ranking in of loss per unit of limiting factors (press hour) would be (highest loss per unit), A and B. The capacity available should, therefore, be deployed for making D first and then A and thereafter B.

29

Q No. 09: A company manufactures two models of a pocket calculator. The basic model sells for Rs: 5, has a direct material cost of Rs: 1.25 and requires 0.25 hours of labour time to produce. The other model, the Scientist, sells for Rs: 7.50, has a direct material cost of Rs: 1.63 and takes 0.375 hours to produce. Labour, which is paid at the rate of Rs: 6 per hour, is currently very scarce, while demand for the company’s calculators is heavy. The company is currently producing 8,000 of the basic model and 4,000 of the Scientist model per month, while fixed costs are Rs: 24,000 per month. An overseas customer has offered the company a contract, worth Rs: 35,000, for a number of calculators made to its requirements. The estimating department has ascertained the following facts in respect of the work: · The labour time for the contract would be 1,200 hours. · The material cost would be Rs: 9,000 plus the cost of a particular component not normally used in the company’s models. · These components could be purchased from a supplier for Rs: 2,500 or alternatively, they could be made internally for a material cost of Rs: 1,000 and an additional labour time of 150 hours. Requirement Advise the management as to the action they should take.

Solution In view of its scarcity, labour is taken as the limiting factor. The decision on whether to make or buy the component has to be made before it can be decided whether or not to accept the contract. In order to do this the contribution per labour hour for normal production must first be calculated, as the contract will replace some normal production.

Normal products Basic Scientist Model - 1 Rs: 5.00

Selling price Materials Labour Contribution

1.25 1.50

÷

1.63 2.25

2.75

÷

Limiting Factor(Direct Labour Hr. P.U) Contribution per direct labour hour

0.25 9.00

Model – 2 Rs: 7.50 3.88

÷ 0.375 9.65

Therefore, if the company is to make the component it would be better to reduce production of the basic model, in order to accommodate the special order. The company should now compare the costs of making or buying the component. An opportunity cost arises due to the lost contribution on the basic model. Special contract Manufacture of component Rs: 1,000 900 1,350 3,250

Materials Labour (Rs: 6 *150 hours) Opportunity cost (150 hours * Rs: 9.00)

Since this is higher than the bought-in price of Rs: 2,500 the company would be advised to 30

buy the component from the supplier if they accept the contract. The contract can now be evaluated:

Contract contribution Sales revenue Materials Component Labour (Rs: 6 * 1,200) Contribution

Rs. 35,000 Rs. 9,000 Rs. 2,500 Rs. 7,200

÷

Rs. (18,700) Rs. 16,300

÷

Total Labour Hours Contribution per direct labour hour

1200 Rs. 13.58

Since the contribution is higher than either of the existing products, the company should accept the contract assuming this would not prejudice the market for existing products. As the customer is overseas this seems a reasonable assumption. Because the contribution is higher for the Scientist model it would be wise to reduce production of the basic model. However, the hours spent on producing the basic model per month are 8,000 units * 0.25 hours = 2,000, and so the contract would displace more than a fortnight’s production of the basic model. The recommendation assumes that this can be done without harming long-term sales of the basic model.

31

Q No. 10:R Co manufactures control s for fire alarms, a very profitable product. Every product comes with a one year warranty offering free repairs if any faults arise in this period. It currently produces and sells 80,000 units per annum, with production of them being restricted by the short supply of labour. Each control includes two main components – one key pad and one display screen. At present, R Co manufactures both of these components in-house. However, the company is currently considering outsourcing the production of keypads and/or display screens. A newly established company based in BB is keen to secure a place in the market, and has offered to supply the keypads for the equivalent of $4·10 per unit and the display screens for the equivalent of $4·30 per unit. This price has been guaranteed for two years. The current total annual costs of producing the keypads and the display screens are: Keypads Display screens Production 80,000 units 80,000 units $’000 $’000 Direct materials 160 116 Direct labour 40 60 Heat and power costs 64 88 Machine costs 26 30 Depreciation and insurance costs 84 96 Total annual production costs 374 390 Notes. (1) Materials costs for keypads are expected to increase by 5% in six months’ time; materials costs for display screens are only expected to increase by 2%, but with immediate effect. (2) Direct labour costs are purely variable and not expected to change over the next year. (3) Heat and power costs include an apportionment of the general factory overhead for heat and power as well as the costs of heat and power directly used for the production of keypads and display screens. The general apportionment included is calculated using 50% of the direct labour cost for each component and would be incurred irrespective of whether the components are manufactured in-house or not. (4) Machine costs are semi-variable; the variable element relates to set up costs, which are based upon the number of batches made. The keypads’ machine has fixed costs of $4,000 per annum and the display screens’ machine has fixed costs of $6,000 per annum. Whilst both components are currently made in batches of 500, this would need to change, with immediate effect, to batches of 400. (5) 60% of depreciation and insurance costs relate to an apportionment of the general factory depreciation and insurance costs; the remaining 40% is specific to the manufacture of keypads and display screens.

Required (a) Advise R Co whether it should continue to manufacture the keypads and display screens in-house or whether it should outsource their manufacture to the supplier in BB, assuming it continues to adopt a policy to limit manufacture and sales to 80,000 control s in the coming year. (b) R Co takes 0.5 labour hours to produce a keypad and 0.75 labour hours to produce a 32

display screen. Labour hours are restricted to 100,000 hours and labour is paid at $1 per hour. R Co wishes to increase its supply to 100,000 control s (ie 100,000 each of keypads and display screens). Advise R Co as to how many units of keypads and display s they should either manufacture and/or outsource in order to minimise their costs. Solution: (a) Incremental costs of making in-house compared to cost of buying Keypads (K) $ Variable costs Materials: K = ($160k × 6/12) + ($160k × 1.05 × 6/12) : D = ($116k × 1.02) 164,000 Direct labour 40,000 Machine set-up costs: K = ($26k – $4k) × 500/400 : D = ($30k – $6k) × 500/400 27,500 (A) 231,500 Attributable fixed costs Heat and power: K = ($64k – $20k) : D = ($88k – $30k) 44,000 Fixed machine costs 4,000 Depreciation and insurance: K = ($84k × 40%) : D = ($96k × 40%) 33,600 (B) 81,600 Total incremental costs of making in-house (A + B) 313,100 Cost of buying: K = (80,000 × $4.10) : D = (80,000 × $4.30) ( 328,000) Total saving from making 1 4,900

Display screens (D) $

118,320 60,000 30,000 208,320 58,000 6,000 38,400 102,400 310,720 (344,000) 33,280

Alternative approach (Relevant costs) Keypads (K)

$

Display screens (D)

$

Direct materials: K = ($160k / 2) + ($160k / 2 × 1.05) : D = $116k × 1.02 164,000 118,320 Direct labour 40,000 60,000 Heat and power K = $64K – (50% × $40K) : D = $88k – (50% × $60k) 44,000 58,000 Machine set-up costs: Avoidable fixed costs 4,000 6,000 Activity related costs (W1) 27,500 30,000 Avoidable depreciation and insurance costs: K = ($84k × 40%) : D = ($96k × 40%) 33,600 38,400 Total relevant manufacturing costs 313,100 310,720 Relevant cost per unit (313100/80000;310720/80000) 3.91375 3.884 Cost per unit of buying in (given) (4.10) ( 4.30) Incremental cost of buying in 0.18625 0.416 As each of the components is cheaper to make in-house than to buy in, the company should continue to manufacture both products in-house. Working Current no. of batches produced = 80,000 / 500 = 160 New no. of batches produced = 80,000 / 400 = 200 Current cost per batch for keypads = ($26,000 – $4,000) / 160 = $137.50 Therefore new activity related batch cost = 200 × $137.50 = $27,500 Current cost per batch for display screens = ($30,000 – $6,000) / 160 = $150 Therefore new activity related batch cost = 200 × $150 = $30,000

33

(b) Note. Attributable fixed costs are not included in the following calculation. Attributable

fixed costs remain unaltered irrespective of the level of production of keypads and display screens, because as soon as one unit of either is made, the costs rise. We know that we will make at least one unit of each component as both are cheaper to make than buy. They are therefore an irrelevant common cost. Plan to minimise costs minimise costs Keypads (K)

Buy-in price Variable cost of making: K = ($231,500 / 80,000): D = ($208,320 / 80,000) Saving from making (per unit) Labour hours per unit Saving from making (per unit of limiting factor) Priority for making Total labour hours available = 100,000 hours

Display screens (D)

$ 4.10

$ 4.30

2.89 1.21 0.50 2.42 1

2.60 1.70 0.75 2.27 2

Make maximum keypads, ie 100,000 using 50,000 labour hours (100,000 × 0.5 hours per unit) Use remaining 50,000 labour hours to make 66,666 display screens (50,000 / 0.75 hours per unit)

Therefore buy in 33,334 display screens (100,000 – 66,666).

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Q No. 11:The management of Spinner plc is considering next year’s production and purchase budgets. One of the components produced by the company, which is incorporated into another product before being sold, has a budgeted manufacturing cost as follows: (£) Direct material 14 Direct labour (4 hours at £3 per hour) 12 Variable overhead (4 hours at £2 per hour) 8 Fixed overhead (4 hours at £5 per hour) 20 Total cost 54 per unit Trigger plc has offered to supply the above component at a guaranteed price of £50 per unit. Required: (a) Considering cost criteria only, advise management whether the above component should be purchased from Trigger plc. Any calculations should be shown and assumptions made, or aspects which may require further investigation should be clearly stated. (b) Explain how your above advice would be affected by each of the two separate situations shown below. (i) As a result of recent government legislation if Spinner plc continues to manufacture this component the company will incur additional inspection and testing expenses of £56 000 per annum, which are not included in the above budgeted manufacturing costs. (ii) Additional labour cannot be recruited and if the above component is not manufactured by Spinner plc the direct labour released will be employed in increasing the production of an existing product which is sold for £90 and which has a budgeted manufacturing cost as follows: (£) Direct material 10 Direct labour (8 hours at £3 per hour) 24 Variable overhead (8 hours at £2 per hour) 16 Fixed overhead (8 hours at £5 per hour) 40 90 per unit All calculations should be shown. (c) The production director of Spinner plc recently said: ‘We must continue to manufacture the component as only one year ago we purchased some special grinding equipment to be used exclusively by this component. The equipment cost £100 000, it cannot be resold or used elsewhere and if we cease production of this component we will have to write off the written down book value which is £80 000.’ Solution: (a) (£) Purchase price of component from supplier 50 Additional cost of manufacturing (variable cost only) 34 Saving if component manufactured 16 The component should be manufactured provided the following assumptions are correct: (i) Direct labour represents the additional labour cost of producing the component. (ii) The company will not incur any additional fixed overheads if the component is manufactured. (iii) There are no scarce resources. Therefore the manufacture of the component will not restrict the production of other more profitable products. 35

(b) (i) Additional fixed costs of £56 000 will be incurred, but there will be a saving in purchasing costs of £16 per unit produced. The break-even point is 3500 units (fixed costs of £56 000/£16 per unit saving). If the quantity of components manufactured per year is less than 3500 units then it will be cheaper to purchase from the outside supplier. (ii) The contribution per unit sold from the existing product is £40 and each unit produced uses 8 scarce labour hours. The contribution per labour hour is £5. Therefore if the component is manufactured, 4 scarce labour hours will be used, resulting in a lost contribution of £20. Hence the relevant cost of manufacturing the components is £54, consisting of £34 incremental cost plus a lost contribution of £20. The component should be purchased from the supplier. (c) The book value of the equipment is a sunk cost and is not relevant to the decision whether the company should purchase or continue to manufacture the components. If we cease production now, the written-down value will be written off in a lump sum, whereas if we continue production, the written down value will be written off over a period of years. Future cash outflows on the equipment will not be affected by the decision to purchase or continue to manufacture the components.

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International outsourcing. Q No. 12:Bernie’s Bears, Inc., manufactures plush toys in a facility in Cleveland, Ohio. Recently, the company designed a group of collectible resin figurines to go with the plush toy line. Management is trying to decide whether to manufacture the figurines themselves in existing space in the Cleveland facility or to accept an offer from a manufacturing company in Indonesia. Data concerning the decision follows: Expected annual sales of figurines (in units) Average selling price of a figurine

400,000 $5

Price quoted by Indonesian company, in Indonesian Rupiah (IDR), for each figurine

Current exchange rate 9,100 IDR = $1 Variable manufacturing costs

27,300 IDR

$2.85 per unit

Incremental annual fixed manufacturing costs associated with the new product line

$200,000

Variable selling and distribution costs* $0.50 per unit Annual fixed selling and distribution costs* $285,000 * Selling and distribution costs are the same regardless of whether the figurines are manufactured in Cleveland or imported. Required 1. Should Bernie’s Bears manufacture the 400,000 figurines in the Cleveland facility or purchase them from the Indonesian supplier? Explain. 2. Bernie’s Bears believes that the US dollar may weaken in the coming months against the Indonesian Rupiah and does not want to face any currency risk. Assume that Bernie’s Bears can enter into a forward contract today to purchase 27,300 IDRs for $3.40. Should Bernie’s Bears manufacture the 400,000 figurines in the Cleveland facility or purchase them from the Indonesian supplier? Explain. 3. What are some of the qualitative factors that Bernie’s Bears should consider when deciding whether to outsource the figurine manufacturing to Indonesia? Solution: 1. Cost to purchase each figurine from Indonesian supplier = 27,300 IDR / 9,100 IDR/$ =$3 Cost of purchasing 400,000 figurines from Indonesian supplier = $3 x 400,000 figurines = $1,200,000.

= $2.85 400,000 units + $200,000 = $1,340,000 Variable and fixed selling and distribution costs are irrelevant because they do not differ between the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing the figurines in Cleveland. Bernie’s Bears should purchase the figurines from the Indonesian supplier because the cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in Cleveland.

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2. If Bernie’s Bears enters into a forward contract to purchase 27,300 IDRs for $3.40, each figurine acquired from the Indonesian supplier will cost $3.40. Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40 x 400,000 figurines = $1,360,000. Cost of manufacturing 400,000 figurines in Cleveland (see requirement 1) = $1,340,000. As in requirement 1, selling and distribution costs are irrelevant. Bernie’s Bears should manufacture the figurines in Cleveland because the relevant cost of $1,340,000 to manufacture the figurines in Cleveland is less than the cost of $1,360,000 to enter into the forward contract and purchase the figurines from the Indonesian supplier. 3. In deciding whether to purchase figurines from the Indonesian supplier, Bernie’s Bears should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of the Indonesian Rupiah relative to the U.S. dollar, and (d) the negative public and media reaction to not providing jobs in Cleveland and instead ing job creation in Indonesia.

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Q No. 13:Oxford Engineering manufactures small engines. The engines are sold to manufacturers who install them in such products as lawn mowers. The company currently manufactures all the parts used in these engines but is considering a proposal from an external supplier who wishes to supply the starter assemblies used in these engines. The starter assemblies are currently manufactured in Division 3 of Oxford Engineering. The costs relating to the starter assemblies for the past 12 months were as follows: Direct materials $200,000 Direct manufacturing labor 150,000 Manufacturing overhead 400,000 Total $750,000 Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for each starter assembly is $5 ($750,000 ÷ 150,000). Further analysis of manufacturing overhead revealed the following information. Of the total manufacturing overhead, only 25% is considered variable. Of the fixed portion, $150,000 is an allocation of general overhead that will remain unchanged for the company as a whole if production of the starter assemblies is discontinued. A further $100,000 of the fixed overhead is avoidable if production of the starter assemblies is discontinued. The balance of the current fixed overhead, $50,000, is the division manager’s salary. If production of the starter assemblies is discontinued, the manager of Division 3 will be transferred to Division 2 at the same salary. This move will allow the company to save the $40,000 salary that would otherwise be paid to attract an outsider to this position. Tidnish Electronics, a reliable supplier, has offered to supply starter-assembly units at $4 per unit.Because this price is less than the current average cost of $5 per unit, the vice president of manufacturing is eager to accept this offer. On the basis of financial considerations alone, should the outside offer be accepted? Show your calculations. (Hint: Production output in the coming year may be different from production output in the past year.) 2. How, if at all, would your response to requirement 1 change if the company could use the vacated plant space for storage and, in so doing, avoid $50,000 of outside storage charges currently incurred? Why is this information relevant or irrelevant? 1.

Solution: 1. The variable costs required to manufacture 150,000 starter assemblies are Direct materials $200,000 Direct manufacturing labor 150,000 Variable manufacturing overhead 100,000 Total variable costs $450,000 The variable costs per unit are $450,000 ÷ 150,000 = $3.00 per unit. Let X = number of starter assemblies required in the next 12 months. The data can be presented in both ―all data‖ and ―relevant data‖ formats:

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The number of units at which the costs of make and buy are equivalent is All data analysis: $340,000 + $3X = $200,000 + $4X X = 140,000 or Relevant data analysis: $190,000 + $3X = $50,000 + $4X X = 140,000 Assuming cost minimization is the objective, then • If production is expected to be less than 140,000 units, it is preferable to buy units from Tidnish. • If production is expected to exceed 140,000 units, it is preferable to manufacture internally (make) the units. • If production is expected to be 140,000 units, Oxford should be indifferent between buying units from Tidnish and manufacturing (making) the units internally.

2. The information on the storage cost, which is avoidable if self-manufacture is discontinued, is relevant; these storage charges represent current outlays that are avoidable if self-manufacture is discontinued. Assume these $50,000 charges are represented as an opportunity cost of the make alternative. The costs of internal manufacture that incorporate this $50,000 opportunity cost are All data analysis: $390,000 + $3X Relevant data analysis: $240,000 + $3X Alternatively stated, we would add the following line to the table shown in requirement 1 causing the total costs line to change as follows:

The number of units at which the costs of make and buy are equivalent is All data analysis: $390,000 + $3X = $200,000 + $4X X = 190,000 Relevant data analysis: $240,000 + $3X = $ 50,000 + $4X X = 190,000 If production is expected to be less than 190,000, it is preferable to buy units from Tidnish. If production is expected to exceed 190,000, it is preferable to manufacture the units internally.

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Q No. 14:The Weaver Company produces gas grills. This year’s expected production is 20,000 units. Currently, Weaver makes the side burners for its grills. Each grill includes two side burners. Weaver’s management ant reports the following costs for making the 40,000 burners: Cost per Unit Costs for 40,000 Units Direct materials $5.00 $200,000 Direct manufacturing labor 2.50 100,000 Variable manufacturing overhead 1.25 50,000 Inspection, setup, materials handling 4,000 Machine rent 8,000 Allocated fixed costs of plant istration, taxes, and insurance 50,000 Total costs $412,000 Weaver has received an offer from an outside vendor to supply any number of burners Weaver requires at $9.25 per burner. The following additional information is available: a. Inspection, setup, and materials-handling costs vary with the number of batches in which the burners are produced. Weaver produces burners in batch sizes of 1,000 units. Weaver will produce the 40,000 units in 40 batches. b. Weaver rents the machine used to make the burners. If Weaver buys all of its burners from the outside vendor, it does not need to pay rent on this machine. Required 1. Assume that if Weaver purchases the burners from the outside vendor, the facility where the burners are currently made will remain idle. On the basis of financial considerations alone, should Weaver accept the outside vendor’s offer at the anticipated volume of 40,000 burners? Show your calculations. 2. For this question, assume that if the burners are purchased outside, the facilities where the burners are currently made will be used to upgrade the grills by adding a rotisserie attachment. (Note: Each grill contains two burners and one rotisserie attachment.) As a consequence, the selling price of grills will be raised by $30. The variable cost per unit of the upgrade would be $24, and additional tooling costs of $100,000 per year would be incurred. On the basis of financial considerations alone, should Weaver make or buy the burners, assuming that 20,000 grills are produced (and sold)? Show your calculations. 3. The sales manager at Weaver is concerned that the estimate of 20,000 grills may be high and believes that only 16,000 grills will be sold. Production will be cut back, freeing up work space. This space can be used to add the rotisserie attachments whether Weaver buys the burners or makes them in-house. At this lower output, Weaver will produce the burners in 32 batches of 1,000 units each. On the basis of financial considerations alone, should Weaver purchase the burners from the outside vendor? Show your calculations. Solution: 1. Relevant costs under buy alternative: Purchases, (40,000 x $9.25) Relevant costs under make alternative: Direct materials Direct manufacturing labor Variable manufacturing overhead Inspection, setup, materials handling Machine rent Total relevant costs under make alternative

$370,000 $200,000 100,000 50,000 4,000 8,000 $362,000 41

The allocated fixed plant istration, taxes, and insurance will not change if Weaver makes or buys the burners. Hence, these costs are irrelevant to the make-or-buy decision. The analysis indicates that it is less costly for Weaver to make rather than buy the burners from the outside supplier. 2. Relevant costs under the make alternative: Relevant costs (as computed in requirement 1) Relevant costs under the buy alternative: Costs of purchases (40,000 x $9.25) Additional fixed costs Additional contribution margin from using the space where the burners were made to upgrade the grills by adding rotisserie attachments, 20,000 ($30 – $24) Total relevant costs under the buy alternative Weaver should buy the side burners from an outside vendor and use its grills.

$362,000 $370,000 100,000

(120,000) $350,000 its own capacity to upgrade

3. In this requirement, the decision on making the rotisserie attachments is irrelevant to the analysis because the rotisserie attachments increase operating income and they will be made whether the burners are purchased or made. Relevant cost of manufacturing burners: Variable costs, ($5 + $2.50 + $1.25 = $8.75) x 32,000 $280,000 Batch costs, $100/batch* 32 batches 3,200 Machine rent 8,000 $291,200 Relevant cost of buying burners, $9.25 32,000 *$4,000

$296,000

40 batches = $100 per batch

In this case, Weaver should make the burners.

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