Question

Question 3: Make versus buy

You make refrigerators. Currently, you manufacture compressors for your refrigerators in-house. An outside supplier has offered to sell you equivalent compressors at a wholesale price of $75 per unit. You need 1,000 compressors per month. The internal production costs per compressor are as follows:

	cost per unit
direct materials	$20
direct labor	$30
variable overhead	$20
fixed overhead	$20
total	$90

If you outsource the production of compressors (the buy option) in the short term, how will this choice affect your costs and profit?

First, compute variable costs under MAKE versus BUY:

	MAKE	BUY
unit VC
total VC

If you outsource (BUY), the incremental revenue, costs, and profit are:

	how much each amount changes if you outsource
Incremental revenue
Incremental VC
Incremental CM
Incremental FC
Incremental profit

Enter negative amounts with a minus sign, i.e., -1,000 not ($1,000).

Should you outsource?

NO - outsourcing reduces profit by $5,000

YES - outsourcing reduces costs by $5,000    

Answer 1

Hi,

Let us start by understanding what is variable cost and what is fixed cost.

Variable cost is cost which is directly related to units produced. It changes according to level of production. If production is less VC is less, and vice versa. Material cost, production labour cost are examples of VC.

Fixed cost is cost which is not related to units produced. This cost has to be incurred even if production is carried out or not. Examples of it are rent, office staff costs, etc.

So first we need to understand what is VC in both alternatives.

In buy option it is very simple i.e. $75 per unit. Under make option VC cost p.u. is sum of direct material, direct labor and variable overheads i.e. $70

If we take one months time period, i.e. 1000 units

Variable Cost under MAKE or BUY
For 1000 units	MAKE	BUY
Unit VC	70	75
Total VC	70000	75000

Once this is know all other calculations are simple as fixed cost under both options will remain same.

	How much each amount changes if you outsource (BUY)	Reason
Incremental revenue	0	Revenue wont change as units are same in both scenarios
Incremental VC	-5000	Total VC under BUY is higher
Incremental CM	-5000	Contribution Margin = Revenue - VC
Incremental FC	0	FC wont change
Incremental Profit	-5000	Profit = Contribution Margin - FC

Since incremental profit is negative $5000 it implies that profit will reduce by $5000 if BUY option is selected.

So, answer to the question "Should you outsource?" is No