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Make (outsourcing) or Buy; Sell As Is or Process Further - Accounting video - YouTube
Channel: Dr. Brian Routh
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This is part 5 in our short-term
business decisions series and here we're
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going to be discussing outsourcing and
process further decisions. So first we'll
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talk about outsourcing and things that
management need to think about when
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deciding whether to outsource. How do our variable costs compare to outsourcing
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costs? Remember fixed costs typically you can't get rid of. In some instances you
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can. So variable costs are what we really
focus on. Variable costs are created when
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we produce a product, so if we outsource
those variable costs are likely to
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disappear. Are the fixed costs really
avoidable if we outsource? So for example,
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rent on a manufacturing building. Well we
may not need the manufacturing building
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anymore if we outsource, so that would be an avoidable fixed cost that we could
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get rid of if we outsourced. What can be
done with freed capacity? So we have to
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think about our opportunity costs.
So what are we foregoing by not
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outsourcing? So for example if we own the building, if we outsourced, we could rent
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the building out. So by not outsourcing,
we are foregoing the rent that we could
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be earning on our building. That's an
opportunity cost. So let's look at the
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decision rules of whether we should
outsource or not. If the incremental cost
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of making a product exceed the
incremental costs of outsourcing
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then we should outsource. That means it
costs more for us to make it than for us
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to buy it somewhere else.
If the incremental cost of making the
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product are less than incremental cost
of outsourcing, or buying it from
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somewhere else, then we do not outsource.
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Let's also look at the decision whether
we should sell a product as it is or
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process it further. So with, just as with
all these other decisions where we're
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looking at there are things management
must consider. For example, how much
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revenue is generated if we sell the
product as it is and compare that with
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how much revenue is generated if we sell
the product after processing it further?
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Keep in mind typically if you process a
product further there's going to be
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additional costs involved. And how much
will it cost to process the product
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further? Now let's look at the decision
rule. So should we sell as is or process
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further? If the extra revenue from
processing further exceeds the extra
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cost of processing further then we
should go through with processing the
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product further. If the extra revenue
from processing further is less than the
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extra cost involved in processing
further then we should sell as is and do
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not process the product further. Let's
look at an example with gasoline. So we
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see here that we have $125,000 in sunk
cost for producing 50,000 gallons of
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regular gasoline. We have two choices: we can sell as is or we can process further.
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If we sell as is, we will have $190,000
in sales revenue. If we process further,
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we'll have $200,000 in sales revenue.
There's no additional cost if we sell as
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is. Looking straight on here well we
should, we should process further because
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we're getting $10,000 more in revenue but
remember what we said earlier: there's
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typically a cost involved when you
process a product further just as in
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this case there is a cost involved. With
sale as is, there is not a cost involved.
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However with processing further, we would need to pay $7,500 in additional costs to
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process the product further. So now we
have to take in consideration that
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there's $10,000 more in
revenues if we process further, but
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there's also $7,500 in additional costs of processing
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further. However since $10,000 is higher than $7,500 then
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we should process the product further.
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