Industrial engineering

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Make or Buy Decisions – Issues
in Fixed and Variable Cost
EIND 142
Paul Kauffmann, PhD, PE
Overview
• 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
2
Chapter 3 Cost Issues
3
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.
4
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
5
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
activities?
– What is current business strategy?
– Consider Dell and Ford.
6
Vertical Integration Issues
• There are many questions in vertical
integration. Consider a foundry in a
shipyard:
– Pricing within the firm: do you charge the cost
or the market price? Are the accounting costs
accurate?
– 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?
7
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?
8
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
9
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.
10
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.)
11
Example of the Cost Accounting
Problem
• Annual volume of an item is 10,000 units
and it is sold for $5.
– A supplier has proposed $4 apiece.
• Cost accounting has proposed
“outsourcing” and shutting down in house
production.
– Here is the analysis
12
The Cost Accounting Picture
Cost Item
Direct Material
Direct Labor
Indirect Labor: supervision
Indirect Overhead
Cost per unit
1.00
4.00
1.20
0.50
Annual Total
10,000
40,000
12,000
5,000
Total cost
Total revenues
6.70
5.00
67,000
50,000
The plant manager has assigned you to look into this issue and make a recommendation.
Should the product be outsourced based on data from the cost accounting system?
13
The Findings- Indirect Overhead
• Manufacturing takes place in a 1000 ft2 area of an
unused warehouse on the main plant site. Nothing
is planned for this area in the future and the
indirect overhead charge is 5$ 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?
14
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?
15
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
labor.
• The cost is derived from the allocation of one
equivalent full time person.
• What check will not be written?
16
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?
17
Conclusion
• Should the company buy the product
outside?
– What checks will not be written or be written if
the product is outsourced for $4 each?
– How much were we about to waste?
– We have not discussed any strategic issues.
What are they?
18
Fixed and Variable Costs
• Fixed and variable costs are another way to
analyze decisions on production that
involve volume questions.
– Variable costs roughly correspond to direct
costs. They change with production levels.
– Fixed costs correspond to indirect costs.
Generally constant over a range of production
levels.
• Example follows
19
Fixed and Variable Costs
Graphically
What line
Cost
represents
fixed,
variable, and
total
?
?
?
Production
20
Break Even Point
Breakeven is where
cost = revenue
Revenue
Total cost
Cost or
Variable
Revenue ($)
Fixed
Why is the
revenue slope
greater than
total cost?
Production (units)
Where are you
losing $- where
do you make $?
21
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
22
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
23
Graphical View
Total cost = $1.6M
Variable =
$600k
Total Fixed
= $1M
$
Volume
4000
24
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
costs!
• What is the savings on this idea?
25
The Analysis
• Volume is now 2000 units – Find the real
checks!
• 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?
26
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)
27
Conclusions
• Supply chain decisions and material
management decisions rely on accurate cost
accounting
– 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
28

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