Industrial engineering

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Make or Buy Decisions – Issues
in Fixed and Variable Cost
EIND 142
Paul Kauffmann, PhD, PE
• What is the core business?
– Relate business functions to business strategy.
• Make – buy supply chain decisions: Do we
know our costs?
– Direct and indirect
– Fixed and variable
• Analytical examples
Chapter 3 Cost Issues
The “Core Business” Question
• “Core business analysis:” what is the core
business and how do departments /
operations support this.
– The question: why perform certain tasks /
functions “in house.” (What are good reasons?)
– What other ways are there to obtain the same
service level (or better) at less cost?
– OR… is this knowledge / capability essential?
• Often called “Make- buy” decisions
– Need a strategic perspective.
Evaluating Alternatives – Costs
• Once alternatives to obtain a service are
identified, next steps include:
– Thorough analysis involving costs, benefits,
and levels of service.
• Must consider competitive advantage
Vertical Integration
• “Vertical integration” describes corporate
ownership of business activities (or layers)
related to a product or service.
– Wide options: mine raw materials to operate the
store that sells the product
– Where do you begin and end the business
– What is current business strategy?
– Consider Dell and Ford.
Vertical Integration Issues
• There are many questions in vertical
integration. Consider a foundry in a
– Pricing within the firm: do you charge the cost
or the market price? Are the accounting costs
– Are you selling on the open market or is this a
captive operation? Is it fully utilized?
– If captive, how can a non- market oriented
operation be cost effective and efficient?
– Should it be? What if it is a strategic necessity?
Systems Engineering Assignment
• Assume you work for Ford and you are assigned
to a project to “strategically” examine what Ford
should do on producing engine blocks.
Alternatives are:
– Produce 100% in house
– Buy from contractors 100% (based on price?)
– Do a percentage in house and buy a percentage (what
should this be?)
• List and explain a reason for and against each of
these options (don’t be too brief or too long but
justify your view).
• What is your choice and why?
Costs and Revenues
• “Make-buy” decisions often fail or succeed
based on the accuracy of cost analysis.
– What will happen with scenario A compared to
scenario B?
• Consider only “real” money in the analysis
– Can you find a check written or not written?
– Don’t be mislead by accounting information
The Cost Accounting Problem
• Cost accounting should support the business
decisions of the operating managers – not
make life easy for accountants.
– Typical goal: make it simple to develop and
report on the budget.
– But does this provide “actionable” information
to operating departments?
– Result: Operating departments make decisions
with inaccurate information.
Basic Cost Review
• Direct costs: incurred directly in producing
the good or service
– Material
– Labor
• Indirect costs: incurred indirectly by the
good or service
– overhead
– staff and support groups (maintenance,
purchasing, accounting, etc.)
Example of the Cost Accounting
• Annual volume of an item is 10,000 units
and it is sold for $5.
– A supplier has proposed $4 apiece.
• Cost accounting has proposed
“outsourcing” and shutting down in house
– Here is the analysis
The Cost Accounting Picture
Cost Item
Direct Material
Direct Labor
Indirect Labor: supervision
Indirect Overhead
Cost per unit
Annual Total
Total cost
Total revenues
The plant manager has assigned you to look into this issue and make a recommendation.
Should the product be outsourced based on data from the cost accounting system?
The Findings- Indirect Overhead
• Manufacturing takes place in a 1000 ft2 area of an
unused warehouse on the main plant site. Nothing
is planned for this area in the future and the
indirect overhead charge is 5$ per square ft. per
year. This product is not energy intensive.
• The electric bill is $500,000, utilities are
$150,000, and building and grounds maintenance,
janitorial etc. are another $850,000. There are
300,000 ft2 on site.
• What is the origin of the $5 and is it justified?
The Findings – Supervision
• This $12,000 cost of supervision has been
allocated as one-fifth of a full time supervisor at
$60,000 / yr.
• A supervisor supports this product in conjunction with
regular (full time) duties such as scheduling
maintenance and production planning.
• When production is in process, the supervisor visits
several times a day to assess status.
• Is this cost accurate and justified? What checks
will not be written?
Findings – Direct Labor
• Five “production associates” are reassigned from
“the manpower pool” for an average of one day
per week to produce these items. The accounting
cost of an equivalent person is $40,000 direct
• The cost is derived from the allocation of one
equivalent full time person.
• What check will not be written?
The Findings- Direct Material
• The raw material for the product costs $1 per
square foot and approximately one square foot is
used for each unit.
• However the material is primarily scrap (by
product) resulting from production of another high
volume product.
• Is this cost accurate?
• Should the company buy the product
– What checks will not be written or be written if
the product is outsourced for $4 each?
– How much were we about to waste?
– We have not discussed any strategic issues.
What are they?
Fixed and Variable Costs
• Fixed and variable costs are another way to
analyze decisions on production that
involve volume questions.
– Variable costs roughly correspond to direct
costs. They change with production levels.
– Fixed costs correspond to indirect costs.
Generally constant over a range of production
• Example follows
Fixed and Variable Costs
What line
variable, and
Break Even Point
Breakeven is where
cost = revenue
Total cost
Cost or
Revenue ($)
Why is the
revenue slope
greater than
total cost?
Production (units)
Where are you
losing $- where
do you make $?
Break Even Example
• You consider outsourcing an item.
– Fixed cost of the shop is $1M per year and you
need it for strategic purposes.
– Variable cost per product is $100 for materials
and $50 for labor.
– The item sells for $350
– Current annual volume is 4,000 units
Present Cost situation
• Variable cost per unit is $150.
– Total variable cost is 4,000*$150 = $600,000
• Total fixed cost is $1M.
– Fixed cost per unit is $1M/4000 =$250.
• The shop costs $1.6M per year.
– Variable plus Fixed = $600,000 + $1M.
– Total cost per unit = $150 + $250
Graphical View
Total cost = $1.6M
Variable =
Total Fixed
= $1M
Outsourcing Idea
• Someone has suggested outsourcing 50% of
this volume since a supplier has proposed a
price of $300 per item.
• The idea is that we will save money- since
we need this shop for strategy- reduce
• What is the savings on this idea?
The Analysis
• Volume is now 2000 units – Find the real
• The cost to the company is:
$1M + 2000*150= $1.3M
the cost of the supplier is 2000*300= 600,000
the total cost to the company is now $1.9M
What is our conclusion?
Breakeven Analysis
• What is the breakeven volume for the shop?
Breakeven occurs where Cost = revenue.
X is the number of units.
Cost = fixed + variable = (1M+150x)
Revenue= 350x
Breakeven is the solution of x for (1M+150x)=
350x or x = 5000 units
– (This is where cost = revenue)
• Supply chain decisions and material
management decisions rely on accurate cost
– It is possible to make very poor decisions if
costs are not clearly understood
– Think in terms of real checks!
– Collaborate with cost accounting to develop
good information systems

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