Make or Buy Decisions

 MAKE OR BUY AND OTHER SHORT-TERM DECISIONS

In a make or buy decisions with no limiting factors, the relevant costs are the differential costs between the two options.

Assessing the differences in costs between making a product in house or outsourcing

A make or buy problem involves a decision by an organization .i.e.

ü  Manufacture its own or buy from outside supplier

ü  Do construction by own employees or sub-contract the work

ü  To make internally or buy externally

Make versus buy

1. Production resources may be idle if the component is purchased from outside.
2. Fixed costs of those resources are irrelevant to decision in the short-term as they will be incurred whether the component is made or purchased.
3. Purchase would be recommended, only if the buying price were less than variable costs of internal manufacture.
4. Purchase from outside if the company saves more than cost of making.

Example 1

A company plans to build an extension to its factory.  The estimated costs of carrying out the work in-house are as follows:

                                                    KES

Materials                                 58, 500

Lab our                                    32, 800

Additional overheads             17, 200

Allocated fixed overheads        8, 200

If the extension is built internally, interference to normal production will result in lost contribution to profit of KES28, 500.

An outside contractor has bid KES110, 000 for the job

Required:

Calculate the net gain or loss if the company does its own construction work.

Outsourcing

Outsourcing is the use of external suppliers for finished products, components or services.

This is also known as contract manufacturing or sub-contracting.

 Factors to consider before outsourcing overseas

1. Quality – quality of the overseas producers must be acceptable.
2. The management will also need to be sure that continuity of supply can be guaranteed.
3. The quoted price may not be fixed and could be affected by changes in exchange rates.
4. Management should investigate whether the available capacity freed up can be used to generate additional profits from a different product.
5. Management should consider whether labor morale will be adversely affected by a decision to locate production overseas.

Factors that have led to growth in the use of outsourcing

Companies and government bodies having increasingly tended to concentrate on their core competences- what they are really good at (or set up to achieve) and turn other functions over to specialist contractors.

A company that earns its profits from, say, manufacturing of bicycles, does not also need to have expertise in say, mass catering or office cleaning.

Reasons for this trend include:

1. Specialist contractors can offer superior quality and efficiency- specialist machinery labour, knowledge and skills.
2. Contracting out manufacturing frees capital that can then be invested in core activities such as market research, product definition, product planning, marketing and sales.
3. Contractors have the capacity and flexibility to start production very quickly to meet sudden variation in demand.

Example

Z Ltd is considering whether to administer its own purchase ledger or to use an external accounting service.  It has obtained the following cost estimates for each option:

Internal service department:

                                                                                    Volume

Purchase computer software                                       KES320 pa

Hardware / software maintenance                              KES750 pa

Accounting stationery                                                 KES500 pa

Part-time accounts clerk                                              KES6, 000 pa

External services:

Processing of invoices /credit notes    KES0.50 per document 5, 000 pa

Processing of cheque payments         KES0.50 per cheque 4, 000 pa

Reconciling supplier accounts           KES2.00 per supplier per month 150 suppliers

Required

Determine the cost effectiveness of outsourcing the accounting activities and identify the broad qualitative factors involved.

Shut-down situations

Part of a business may appear to be unprofitable. In evaluating closure the cost accountant should identify:

1. Loss of contribution from the segment
2. Savings in specific fixed costs from closure.
3. Penalties resulting from the closure, e.g. redundancy, compensation to customers.
4. Alternative use for resources released.

Example

Fashion store comprises three departments, men’s wear, ladies wear and unisex.

The store budget is as follows:

                                                Men’s              Ladies             Unisex             Total

Sales                                        40,000             60,000             20,000             120,000

Direct cost of sales                  20,000             36,000             15,000             71,000

Department sales                       5,000             10,000               3,000             18,000

Apportioned store costs            5,000               5,000               5,000             15,000

Profit/ (loss)                            10,000              9,000             (3,000)             16,000

It is suggested that unisex be closed to increase the size of men’s and ladies wear

Required:

Determine what information is relevant or required.

Solution

Possible answers are as follows:

1. Unisex earns KES2,000 net contribution (apportioned costs will still be incurred and thus reapportioned to other departments)
2. Possible increase in Men’s/ladies’ sales volume
3. Will unisex staff be dismissed or transferred to men’s/ ladies?
4. Reorganization costs e.g. repartitioning, stock disposal
5. Loss of customers because unisex attracts certain types of customers who will not buy in men’s/ladies’.

One-off contracts

When a business is presented with the opportunity of one-off contract it should apply relevant costing principles i.e. it should identify the incremental cash flows associated with the project.

Example

On 1 January a company prepared the following budget for a one-off contract.

  KES

Research and development                             50, 000

Material                                                           15, 000

Machinery                                                          5, 000

Lab our                                                            35, 000

Allocated fixed overhead                               25, 000

130, 000

Budgeted selling price                                                200, 000

Profit                                                                 70, 000                                                         

In March, having spent KES30,000 of the research costs and having contracted for the machinery, the company realizes that the completed contract would be sold for only KES100, 000.

Required:

Determine whether the project should be continued

Joint products

ü  Joint products are two or more products which are output from the same processing operation, but which are indistinguishable from each other up their point of separation.

ü  Joint products have a substantial sales value i.e. oil refining where diesel fuel, petrol, paraffin and lubricants are all produced from the same process.

ü  Saleable item should be separately costed

ü  They have split-off point or separation point

ü  Costs incurred prior to this point of separation are common or joint costs.

Example

A joint production can be further processed at cost of KES5 per kg and sold for KES20 per kg.  Alternatively it can be sold at the split-off point for KES17 per kg

Required

Should it be further processed?