Question

Q.2  Toronto Auto Co [TACo], has a parts division that needs 1,000 units of     

        component CX12 per period in making car parts. It can buy the component for

        $1,250 each  or make them under the following conditions:

              Per Unit               Direct materials                                  $    500

                                            Direct manufacturing labour                  250

                                            Variable manufacturing overhead         300

                                            Fixed manufacturing overhead              250

                                                           Total                                      $1,300

      If TACo buys the components from outside, it can avoid 25% of fixed manu-   

      facturing overhead.  

      

Required: Part I

1. Show calculations to prove whether TACo should make or buy the

component.  

2. List additional  non-financial factors the company should use in deciding whether to make or buy the component.   
3. What are the potential dangers of outsourcing in this situation?

Part II

Additionally, if TACo were to manufacture the part in-house, it can use extra capacity to supply another company that uses the same component.

4.               What cost information should be used for pricing the extra units?

Answer 1

ANSWER PART I:

Cost computation if the component is made

Direct materials = 500$

Direct manufacturing labour = 250$

Variable Manufacturing Overhead = 300$

---------

Total Variable cost per unit = 1050$

-----------

Total Variable Cost (for 1000 units) = 1050 x 1000 = 1050000$

Total Fixed cost = 250$

Total cost = Total variable cost + Total Fixed cost

= 1050000 + 250

= 1050250 $

Cost per unit = 1050250 / 1000 = 1050.25$

In case the compent is bought,

cost per unit = 1250 $

Additionally, 25 % fixed cost can be avoided which is = 25% of 250 = 62.50 $

Now the cost per unit is = 1250 - 62.50 = 1187.50 $

Even though the fixed cost gets reduced while buying the component, it will be still cheaper to make it (1150.25 < 1187.50). Thus, TACo should make the component itself rather than buying it.

List of Non- Financial Factors to consider while making a "make or buy" decision:

1. The production capacity of the plant in case it plans to make it.

2. Reliability of the supplier.

3. Reliability of the quality of goods provided by the potential supplier.

4. Competitive advantage in the sense that the company do not want to leak its secret component information to the competitors.

5. Whether the company wants to have the process control.

Potential dangers of outsourcing in this situation are as follows:

1. The company will be incurring more expenses as compared to the case where it produces it itself.

2. Higher costs can lead to lower profits.

3. The company may lose its component information secrecy and the secret will be disclosed to the competitors.

4. The supplier may not be reliable.

5. The supplier may not meet the quality standards of TACo and this will eventually degrade its final product.

ANSWER PART II:

In case TACo manufactures the part in-house and supplies the extra capacity to another company, it will need the following cost information for pricing the extra units:

1. The price charged by other companies for that component so that TACo's price is neither too low nor too high.

2. Transportation cost

3. Selling cost

4. Advertising cost ( in case advertising is needed)

5. Cost of variable and fixed factors.

6. The margin of profit needed.