Question

A company manufactures telephones. The company is currently operating at full capacity and variable manufacturing costs are charged to produce at the rate of 25% of direct labour cost.

Consider the following information:

Direct Materials cost per unit equals to 30€

Direct Labour cost per unit equals to 10€

Normal Production is 50.000 units per year

The 30.000€ of Fixed Manufacturing Overheads cannot be eliminated in case the production stops and will have to be absorbed by other products.

A supplier offers to make the telephones at a price of 40€ each. Should the company buy the telephones from the outside supplier?

Answer 1

The decision to be made is an outsourcing decision often called as 'make or buy' decision. Following table represents savings/benefits of outsourcing the telephone:

Particulars	Notes	Amounts
Savings in direct material costs	1	30
Add: Savings in direct labour costs	1	10
Add: Savings in variance manufacturing costs (25% of Direct labour costs)	1	2.5
Add: Savings in fixed manufacturing costs	2	0
Less: Purchase price of telephone	3	-40
Net effect of outsourcing decision (I.e. Savings per unit in the given case)		2.5

Notes:

1. Direct material costs, direct labor costs and variable manufacturing costs are variable costs which will not be incurred if telephone is outsourced and hence results in savings.
2. Fixed manufacturing costs are to be incurred irrespective of the fact that product is manufactured or outsourced, hence no savings.
3. Payment to supplier is the cost of outsourcing resulting in outflow.

Hence, the company should buy the telephone from supplier as it results in savings of €2.5 per unit of telephone.