Cost Accounting for Decision-making Lesson 3

Different Types of Business Decisions (Hire, Make or Buy) (1) Part III Different Types of Business Decisions (Hire, Make or Buy) (1)

Five Types of Business Decisions Hire, make or buy Accept or reject an order at a special price Eliminate or retain an unprofitable segment Retain or replace equipment Sell or process further Teacher states different types of decision-making situations will be covered in the coming lessons.

Hire, Make or Buy Decisions (Outsourcing) Hire, make or buy decision involves purchasing goods or services from outside suppliers instead of producing from within the company. Sometimes, we call this type of decision making an outsourcing decision. Outsourcing involves hiring other companies to make all or part of a product or to perform all or part of the services. Teacher explains hire, make or buy decisions and introduces the term ‘outsourcing’.

Hire, Make or Buy Decisions (Outsourcing) DECISION RULE If incremental cost of making > incremental cost of outsourcing Outsource If incremental cost of making < incremental cost of outsourcing Do not outsource Teacher explains the decision rule for hire, make or buy decisions.

Example for Hire, Make or Buy (Part 1) A division currently manufactures 10,000 units of ‘CX1’ per annum. The costs are as follows: Total ($) Per unit ($) Direct materials 120,000 12 Direct labour 100,000 10 Variable MOH* 10,000 1 Fixed MOH* 130,000 13 Total costs 360,000 36 * MOH: Manufacturing Overheads Teacher illustrates with an example on the outsourcing decision that would be made under the circumstance that there is no alternative use form the capacity released from outsourcing.

A supplier has offered to supply 10,000 units of ‘CX1’ per annum at a price of $30 per unit. If all the ‘CX1’ are outsourced, the cost on its direct labour will be saved. Direct materials and variable MOH are avoidable, while fixed MOH would be reduced by $10,000 per annum. If the excess capacity from outsourcing ‘CX1’ has no alternative use, should the company make or buy ‘CX1’ ?

Points to Note for Making the Decision All variable costs are relevant for making ‘CX1’. i.e. Direct materials, direct labor and variable MOH. Only $10,000 fixed MOH is relevant because the amount is the cost that can be saved if ‘CX1’ is outsourced. The purchase price of $30 per unit is relevant because it represents the cost of outsourcing ‘CX1’. Teacher explains some points that are relevant to make the decision.

Suggested Solution Relevant cost of Making ($) Outsourcing ($) Direct materials (120,000) Direct labour (100,000) Variable MOH (10,000) Fixed MOH Buying cost incurred (300,000) (240,000) Teacher explains the solution for this example. Making ‘CX1’ by the company is preferred because its relevant cost is $60 000*($300,000 – $240,000) less than the cost of outsourcing.

Example for Hire, Make or Buy (Part B) Let’s assume that the extra from outsourcing ‘CX1’ can be used to manufacture and sell 10,000 units of ‘DX2’ at a price of $34 per unit. It is known that the labour force as well as the variable and fixed MOH for manufacturing each ‘DX2’ would be the same as those incurred for manufacturing each ‘CX1’ . If the materials required for making each ‘DX2’ is $13, should the company outsource ‘CX1’ to produce and sell ‘DX2’? Teacher illustrates another example on the outsourcing decision that would be made under the circumstance that there is alternative use for the capacity released from outsourcing.

Points to Note for Making the Decision Selling price ($34 per unit) for ‘DX2’ is relevant. The costs for making ‘DX2’ is relevant. The incremental costs (i.e. the $60,000 in Part 1) of outsourcing ‘CX1’ is relevant. Teacher explains some points that are relevant to make the decision.

Suggested Solution Revenue from the sale of ‘DX2’ 340,000 $ Revenue from the sale of ‘DX2’ 340,000 Relevant costs of making ‘DX2’ Direct materials (130 000) Direct labour (100 000) Variable MOH (10 000) Fixed MOH (250,000) Profit from selling ‘DX2’ 90,000 Teacher explains the solution for outsourcing example. By using the extra capacity to produce and sell ‘DX2’, an additional profit of $90,000 is earned.

$ The incremental costs of outsourcing ‘CX1’ (60,000)* Contribution from outsource ‘CX1’ and sell ‘DX2’ 90,000 Extra profit 30,000 *(420,000 – 360,000) (extracted from Part 1) Outsource ‘CX1’ and use the extra capacity to produce and sell ‘DX2’ is the preferred option. This will enable the company to gain an extra profit for $30,000 Teacher explains the answers and makes a conclusion.

Activity 1: Class Discussion What other factors the company should consider before making a final decision? Teacher invites students to share their ideas on the decision made in the previous example.

Other Factors to be Considered Control over the product quality Reliability and reputation of the suppliers Possibility of modifying the decision in the future Feasibility to request the supplier to adjust the supply quantity of ‘CX1’ in the future Impact of the decision to customers and other suppliers Teacher makes comments and provides answers.

Classwork Total ($) Direct materials 40,000 Direct labour 60,000 ABC company makes camera lens. The annual costs of ABC Company in producing 10,000 units of camera lens are as follows: Total ($) Direct materials 40,000 Direct labour 60,000 Variable MOH 30,000 Fixed MOH 80,000 An external supplier has made an offer to sell the company a similar lens for $14.5 per unit. If the production of the lens is outsourced, $15,000 of annual fixed MOH could be avoided and the existing facilities could be rented to another company for $50,000 per annum. Teacher explains the question.

Classwork Required: Should ABC company make or buy the lens? What other qualitative factors the company should consider before making a final decision. Teacher asks students to do the calculations and provide comments.

Suggested Solution Relevant costs of Making ($) Outsourcing ($) Direct materials (40,000) Direct labour (60,000) Variable MOH (30,000) Fixed MOH (15,000) Rental income 50,000 Buying cost incurred (145,000) (130,000) (110,000) Teacher explains the solution and makes a conclusion. Teacher highlights the $15,000 and explains that although this amount is a fixed overhead, it could be avoided if the production of lens is outsourced, and thus becomes relevant for decision-making. The company should outsource the production of lens because it can save $20 000*. ($130,000 – $110,000)

Suggested Solution Qualitative factors to be considered: Quality of the lens if outsourced. Reliability and reputation of the supplier in lens production. Contract terms of the outsourcing, such as the duration of the contract. Feasibility to request the supplier to adjust the supply quantity of the lens in the future. Potential feedback from customers if they discover the lenses are not produced by the company. Teacher explains some possible qualitative factors for this question.

Homework: Q3 and Q4 Teacher asks students to do Question 3 and 4 at home.

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