This chapter addresses how managers make short-term outsourcing decisions using incremental analysis. This type of decision is often called a 'make or buy' decision because they involve a decision of whether to continue 'making' (manufacturing) a product versus buying it from an outside. The 'make' part of the decision is called insourcing and the 'buy' part of the decision is called outsourcing. Make or buy decisions can involve products or services. For instance, some companies outsource payroll or internal auditing services, while some companies outsource motors used to build lawnmowers or the production of entire products.
Similar to other types of short-term decisions, outsourcing decisions can be made using either full costing, variable costing, or incremental analysis. Full or variable costing involves preparing two side-by-side income statements and comparing the difference in profit between the two. Incremental analysis is the most effective method because it can be analyzed more quickly, and is the shortest, easiest, and best approach because it helps managers focus on the relevant parts of a decision. A manager that uses full or variable costing wastes time determining costs that will not differ between two decisions.
Outsourcing decisions are based on the difference in the cost of purchasing or buying a product or service from an external supplier compared to the cost of producing the item or providing the service in house.
A few key points about outsourcing decisions should be noted:
1. There are no incremental revenues in outsourcing decisions. The decision is whether to expend costs internally to produce or pay an outsider to produce. Just because a company chooses to outsource does not mean it automatically changes its selling prices.
2. Incremental costs include:
a. Variable costs of production
b. Avoidable fixed costs, i.e., the fixed costs that won’t be incurred if the 'buy' decision is made, or the costs that will be avoided if a particular decision is made. These are the costs that will avoided if the product is NOT produced internally.
c. Cost savings that occur as a result of outsourcing versus insourcing. For example, it a company decides to not manufacture a product, it will save various manufacturing costs including:
1. Direct labor costs - The labor production costs of producing a product that can be directly traced to particular products, such as assembly costs
2. Direct materials costs - The materials used to produce a product that can be directly traced to a particular product, such a parts, wheels, and components
3. Variable overhead costs - The indirect variable costs related to production that exist only because of production, such as factory janitor wages, factory supplies, oil for production machines, etc.
4. Fixed overhead costs, but only if avoidable. While fixed costs in total remain the same no matter what level of production, most are not committed and will continue to be costs to the company even if production is curtailed. . Some fixed costs may be eliminated, such as production supervisor's salary or rent on factory space that can be terminated.
d. Any opportunity cost that may occur if the company outsources instead of producing internally. These costs are amounts given up when a particular course of action is chosen. For example, if a company decides to outsource, it can rent out its manufacturing space to generate rental revenue. The revenue is a cash inflow if the company outsources, but is an amount given up if the company chooses to insource.
Making the Decision
If incremental cost savings are less than incremental costs, the product should continue to be insourced.
If incremental cost savings equal incremental costs, qualitative factors must be used to make the appropriate decision.
If incremental cost savings are greater than incremental costs, the product should be outsourced.
Regardless if the choice is to outsource or insource, a company should always consider the 'touchy-feely' aspects of decision making effects. These include employee morale, goodwill to the community, environmental effects, feasibility, resource availability, etc.
Walk Thru 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. Overhead totals $18 per unit of which $5 is variable. Eighty percent of the fixed overhead is unavoidable. Swingly, Inc. has contacted Walker with an offer to sell the motors for $24 each. In good form in the answer box below, create an incremental analysis for the make or buy decision.
First identify the question being asked. The question is asking about Walker and whether it should outsource. Note that the question could ask from the other side of the situation....whether Swingly should accept the long term offer. Pay close attention to the question at hand.
Remember that there is never any incremental revenue with outsourcing decisions. Begin with the incremental cost to buy which is based on the motors needed. In this case, 4,000 motors at $24 each are needed totaling $96,000. This is a cost to be paid out so it is shown in the analysis as a negative amount representing a decrease in profit.
Because the motors will no longer be manufactured, all variable costs of production are considered to be cost savings. These amounts are added because they reduce costs which in turn cause profits to increase. You should list materials, labor, and variable overhead separately in the analysis. The variable overhead is $5 per motor times the 4,000 motors to be purchased for a total of $20,000. Total materials and total labor are given.
Because 80% of the fixed overhead is unavoidable, the other 20% is avoidable. Avoidable means the cost will no longer be incurred if the motors are outsourced. As a result, 20% of the fixed overhead will differ between the decision options. Twenty percent is avoidable so it is a cost savings if production is outsourced. In this case, $5 per unit is variable, leaving $13 of the $18 per unit as fixed. Twenty percent of the $13 difference is avoidable times the 4,000 units to be outsourced amounting to $10,400 fixed overhead cost savings.
Incremental cost to buy
Incremental cost savings:
Incremental decrease in profit if outsourced
If the motors are outsourced instead of manufactured, the company will incur additional costs of $5,600. The company will more than likely continue to manufacture unless qualitative issues override the loss. Note the distinctive label on the last line of the analysis, 'Incremental decrease in profit if outsourced.' It clearly tells the user how to make the decision.
Special note: Because most fixed costs do not differ in total between decisions, they are usually irrelevant.