This chapter addresses how managers analyze costs to make short-term outsourcing decisions using incremental analysis. This type of decision is often called a 'make or buy' decision because it involves a decision of whether to continue 'making' (manufacturing) a product versus buying it from an outside company. From a business perspective, outsourcing enables a company to reduce costs or benefit from supplier efficiencies.
Incremental Analysis Components
Similar to other types of short-term decisions, incremental analysis is the easiest and quickest approach to analyzing decisions and saves significant time and confusion compared to preparing and comparing side-by-side income statements. The incremental amounts are based on the difference in the cost of buying a product or service from an external supplier compared to the cost of producing the item or providing the service in house. The 'make' part of the decision is called insourcing and the 'buy' part of the decision is called outsourcing. When services are involved, if a company pays another company to provide a service such as internal auditing or payroll, it is called outsourcing. If the company uses its own employees to provide the service, it is considered insourcing.
Incremental costs are the additional costs incurred from outsourcing. The key cost is the purchase price of the products or the cost of the services that are being provided by other companies.
Incremental Cost Savings
Incremental cost savings are reductions of costs that will no longer be incurred as a result of outsourcing. They are often called avoidable costs because if a company outsources, it can 'avoid' certain costs. Variable product cost savings are always incremental. Because they reduce total costs, they cause profits to increase. In some situations, a portion of fixed costs can be saved such as equipment rental costs or supervisor salaries that can be avoided.
When companies evaluate the cost to produce products, they typically list each of the four manufacturing costs separately---direct labor, direct materials, variable overhead, and fixed overhead costs. The first three costs are variable, which are incremental cost savings. Fixed overhead costs that are avoidable are incremental, because these costs can be 'avoided' if outsourcing occurs.
Opportunity costs are the costs forgone as a result of selecting a different alternative. They are always incremental. For example, if a company decides to outsource, it is able to lease its factory space that the product being outsourced no longer will occupy.
Amounts That Are Not Relevant in Outsourcing Decisions
An outsourcing decision is whether to buy a product or service from outside the company or produce it internally---an impact only on the cost. There is no implication of changing the selling price. Just because a company chooses to outsource does not mean it automatically changes its selling prices. As such, incremental revenue is not relevant in outsourcing decisions.
Many fixed costs remain the same in total no matter what level of production. However, some fixed costs can be eliminated if a company decides to outsource. Those that can be eliminated are considered to be avoidable, which implies they are incremental. Some examples include a production supervisor's salary if he will be terminated, or rent on factory space that can be terminated.
Evaluating Outsourcing Decisions
Outsourcing products or services should generally be pursued if profits are expected to increase. It is especially important to consider the qualitative issues as well.
Accept or Reject?
If incremental cost savings plus opportunity costs are less than incremental costs, reject the special order, unless qualitative characteristics overwhelmingly impact the decision.
If incremental cost savings plus opportunity costs are greater than incremental costs, accept the special order unless qualitative characteristics overwhelmingly impact the decision.
If incremental cost savings plus opportunity costs are equal to incremental costs, focus primarily on qualitative characteristics to evaluate the decision.
Regardless if the choice is to outsource or insource, a company should always consider the qualitative aspects of decisions. Qualitative issues related to outsourcing include:
The quality of the insourced product or service
The timeliness of receiving deliveries of the outsourced product or service
The effect on personal lives of employees terminated if outsourcing occurs
The effect on morale of existing employees that become concerned with keeping their jobs once they hear that other employees are being terminated
Walk Through Problem
Walker, Inc. currently manufactures 4,000 motors for its electric scooters annually. Direct material costs are $44,000 and direct labor total $16,000 annually for the motors. Overhead totals $18 per motor of which $5 is variable. Eighty percent of the fixed overhead is unavoidable. Swingly, Inc. has offered to sell the motors to Walker for $24 each. Create an incremental analysis for the outsourcing decision.
Step 1: Determine the incremental cost to buy. The supplier has offered a price of $24 each for the 4,000 motors.
$24.00 x 4,000 = $96,000
This is a cost to be paid out that will reduce profit, so it is shown in the analysis as a negative amount.
Step 2: Determine incremental variable cost savings. Because the motors will no longer be manufactured, all variable product costs are considered to be cost savings. These amounts are added because by reducing costs, they cause profits to increase. You should list materials, labor, and variable overhead separately in the analysis. Total materials and total labor are given. The variable overhead cost savings must be calculated as:
Variable overhead cost savings = $5.00 x 4,000 = $20,000
Step 3: Determine incremental fixed cost savings. Because 80% of the fixed overhead is unavoidable, the other 20% is considered avoidable. Avoidable costs are always relevant because the cost will no longer be incurred if the motors are outsourced. As a result, 20% of the fixed overhead will be eliminated if outsourced, resulting in a cost savings. Of the $18 fixed overhead cost per unit, and given that $5 per unit is variable, the other $13 per motor is fixed. The total fixed overhead cost savings is:
4,000 units x (13 x 20%) = $10,400
Step 4: List the amounts in good form beginning with incremental revenue. The analysis should appear similar to the form of an income statement with descriptive line item labels:
Incremental cost to buy
Incremental cost savings:
Incremental decrease in profit if outsourced
If the motors are outsourced instead of manufactured, it is estimated that the company will incur additional costs of $5,600. Because profit is expected to decline by $5,600, the company should continue to produce internally and not outsource. However, qualitative issues should also be considered.
The label on the last line of the analysis contains three key components:
'Incremental decrease' (or increase) indicates that the change is incremental, and whether the change is an increase or decrease.
'In profit' indicates what financial component the change will affect.
'If outsourced' indicates what action must be taken to achieve the effect.
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Saturday January 03, 2015 08:42 AM
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