Question

Question 5: Relevant information for decisions (20 marks in total)

The development of a new pesticide for the horticultural industry has been successful. David is now discussing with you options to expand operations to include this new line of pesticide, Microcide. A key issue is whether to make one of the components of the pesticide, Factor X, or to buy it in. Demand for the next 12 months is expected to be 200,000 litres. Costs if FOL makes all the components are as follows:

Direct material			$ 1,200,000
Direct labour			$ 190,000
Factory overhead variable			$ 25,000
Factory overhead fixed			$   300,000
Total costs			$ 1,715,000

If FOL buys in the Factor X the unit costs of direct material will increase by 10%. Fixed costs will decrease by 65% representing the costs of the additional section of the production line which are avoided if the Factor X is bought in.

If FOL produces Factor X as part of the joint process of producing Microcide production, there will be a surplus of 30,000 litres of Factor X which can be sold at $4.50 per litre.

Required

1. Prepare a schedule that compares the make or buy alternatives. Show totals and amounts per unit. Calculate the difference between making and buying.
2. Prepare a memo to David outlining the qualitative factors that impact non-routine decision making. Understanding these will help David make the right decision. (500 words)

Answer 1

1.

	MAKE DECISION		BUY DECISION
Particulars	Total Cost	Cost per unit	Total Cost	Cost per unit
Direct Material	$ 12,00,000	$ 6	$ 1320,000	$ 6.6
Direct Labor	$    190,000	$ 0.95	$    190,000	$ 0.95
Variable Factory Overeheads	$      25,000	$ 0.125	$      25,000	$ 0.125
Total Variable Cost	$ 14,15,000	$ 7.075	$ 1535,000	$ 7.675
Fixed Overhead Cost	$    300,000	$ 1.5	$ 105,000	$ 0.525
Total Cost	$ 17,15,000	$ 8.575	$ 1640,000	$ 8.2
Savings due to sale of Excess of Factor X	($   135000)	($ 0.675)	($0)	($ 0)
Relevant Cost of the option	$ 15,80,000	$ 7.90	$ 1640,000	$ 8.2

The difference between the MAKE DECISION AND BUY DECISION is that the decision to make the component reduces the per unit cost by $ 0.30 per unit and reduces the total cost by $ 60000.

Notes:

Particulars	Total Cost	Cost per unit
Direct Material	$ 12,00,000	$ 6
Direct Labor	$    190,000	$ 0.95
Variable Factory Overeheads	$      25,000	$ 0.125
Fixed Overhead	$    300,000

Particulars	Cost of Making	Cost of Buying
Direct Material	$ 6	$ 6.6
Direct Labor	$ 0.95	$ 0.95
Variable Factory Overeheads	$ 0.125	$ 0.125
Total Variable Cost per unit	$ 7.075	$ 7.675
Units	200,000	200,000
Total Variable Cost	$ 1415000	$ 1535,000
Fixed cost	$    300,000	$ 105000
Total Relevant Cost	$ 17,15,000	$ 16,40,000
Less: Savings due to sale of excess Of Factor X ($ 4.5*30,000 litres)	($ 135,000)
Total Relevant cost of the option	$ 15,80,000	$ 16,40,000

2.

In take a decision as to wheter a company should go in for the Buy Option or the Make option, there are various qualitative and quantitative factors that are to be considered. Whether to give more weightage to the qualitative factors or the quantitative factors is a decision that is taken after considering the kind of business the organization is involved in:

1. The qualitative factor that is important and to be considered is the skill and experience of the organization in making the product. Since the organization may not be an expert or may not have specialized in the manufacture of that product only like the company from whom it has been purchased, it may have an effect on the quality of the manufacture . At times though the organization does not have the experience in manufacture of this product, its past experience in manufacturing other products may be or may not be of great help.
2. The quality of the management in terms of its policy making and decision making is a vital point that needs to be considered. The organization cannot influence the decision making of the organization from whom it has procured the product and that will definitely have an influence on this organization that is buying the product from it.
3. Certain other qualitative aspects to be considered are whether the supplier provides after sales service and prompt action in case of any problem as this builds the long term relationship with the vendor which is required for the success of the business.
4. The other qualitative factors that are to be considered are whether the decision to buy the product will adversely affect the morale of the employees within the organization.
5. When the decision to procure is taken, there is no direct control over the quality of the products that could be otherwise exercised if that decision to manufacture that product in-house was taken.
6. There may be other qualitative considerations like union pressure etc that have to be considered.
7. Another qualitative factor is that sometimes the decision to procure from outside may be taken because of the preference for a particular brand so that the organization stands to benefit on account of the brand value.