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Make or buy and product elimination decisions
Published on September 26, 2018 22 min
Other Talks in the Series: Management Accounting
Module number eight. Hello everyone, I would like to welcome you to this HSTalks lecture series, on managerial accounting. My name is Alexander Himme, and I'm an Assistant Professor for Managerial Accounting at the Kuhne Logistics University, in Hamburg Germany. In this module, we will talk about how the concept of relevant information is applied to two very common decisions, that managers have to make. Which is to make or buy, and the product illumination decision. This module is closely linked to the module number seven. There, if already introduced the idea of relevant information.
Let us recall the main principles for making decisions. First, relevant information is expected future data that differs among alternatives. Second, only relevant data affect decisions. Third, sunk costs and allocated costs are common fixed costs that were incurred in the past, and cannot be changed regardless of which future actions is taken. So there are always irrelevant to the decision. Finally, relevant qualitative or non-financial information has the same characteristics as relevant financial information. If managers do not consider relevant qualitative information decision-making, then they may make serious mistakes. In module number seven, you have applied these principles to special pricing and production planning decisions. Now, this module our focus is on make or buy and product elimination decisions.
Let us first look at the make or buy decision, which is also called the outsourcing decision. Seating Inc. which produces wooden chairs, also manufactures the cardboard boxes needed for packaging the chairs for transportation. The cost for producing 2,000 cardboard boxes in a period are as follows; Seating Inc. needs €7,000 for direct material, which is the cardboard. Then, their direct labor cost of €1,000. For instance, for cutting the cardboard. In addition, there are variable manufacturing overhead costs €1200. This could be, for example; the cost for indirect materials like glue, and then they are fixed manufacturing overhead costs of €4,800. These overhead costs could be for example, the depreciation for the cutting machines or the insurance and property taxes for the factory building where the cardboard boxes are manufactured. This gives us total manufacturing costs of €14,000. If we divide these €14,000 by the total amount of manufactured cardboard boxes, which is 2,000 boxes, we receive €7 per box. Now, Seating Inc. receive an offer from Boxing Inc. a company which has specialized in the manufacturing of cardboard boxes. Boxing Inc. offers to sell Seating Inc. cardboard boxes for five Euros per box. Just looking at these numbers and comparing seven and five Euros, it seems that Seating Inc. should outsource the cardboard boxes. But isn't that easy? Let's see.