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Make or Buy Decisions – Issues
in Fixed and Variable Cost
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
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 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.
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 (dont 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
Consider only real money in the analysis
Can you find a check written or not written?
Dont 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
Indirect costs: incurred indirectly by the
good or service
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 $4 apiece.
Cost accounting has proposed
outsourcing and shutting down in house
Here is the analysis
The Cost Accounting Picture
Indirect Labor: supervision
Cost per unit
The plant manager has assigned you to look into this issue and make a recommendation.
Should the product be outsourced based on data from the cost accounting system?
The Findings- Indirect Overhead
Manufacturing takes place in a 1000 ft2 area of an
unused warehouse on the main plant site. Nothing
is planned for this area in the future and the
indirect overhead charge is 5$ 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
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
Fixed and Variable Costs
Break Even Point
Breakeven is where
cost = revenue
Why is the
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
Total cost = $1.6M
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?
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?
What is the breakeven volume for the shop?
Breakeven occurs where Cost = revenue.
X is the number of units.
Cost = fixed + variable = (1M+150x)
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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