Question

Assume you own a company that produces mountain bikes. Your company has manufactured mountain bikes locally in the United States for over 30 years. Because low cost competition is increasingly gaining market share and your company costs are relatively high, you are considering outsourcing production to China.

A. Describe how differential analysis can be used to assist in making this type of make-or-buy decision. Include specific examples related to producing mountain bikes in your response.

B. What additional factors would you consider outside of the financial information analyzed with differential analysis? These are called qualitative factors in the text. Be sure to state why you would consider the qualitative factors included in your response.

Answer 1

(a): In this case the company that manufactures mountain bikes will have to do a differential cost analysis to determine which option i.e. making bikes in USA or buying them from a third party manufacturer in China will be more financially lucrative in terms of lower costs for the company. While doing the differential analysis only relevant costs will have to be considered. By relevant costs I mean costs that are incremental in nature. So all future cash flows, avoidable costs, opportunity costs, and incremental costs will be relevant costs.

For example sake suppose that the production of mountain bikes in USA costs $50 per unit. The breakup of this cost is materials $30, labor $15, fixed overhead costs $3 and variable overhead costs $2. Now if the bikes were purchased from China the fixed overhead costs will continue. So the relevant costs will be 30+15+2 = $47. The company can buy from China at the rate of $48 per unit. While this is lower than the company’s cost of $50 the differential analysis shows us that it is more than the company’s relevant cost of $47. Hence using differential analysis we can say that the company should continue making the mountain bikes in USA itself due to lower relevant costs.

(b): The additional factors that will be considered when making this type of make-or-buy decision are factors like quality of the raw materials that will be used by the producer in China, the production time frame of the Chinese manufacturer, the delivery schedule of the Chinese manufacturer etc.

These qualitative factors will have to be considered so as to ensure that apart from cost factors other factors like quality of the product, manufacturing time, etc. are considered. These qualitative factors will have to be considered because consumers do not buy solely on the basis of price alone and hence the company will have to ensure that whether they are making the bikes in USA or buying it from China the quality of the bikes remain high and the bikes are able to meet the needs and requirements of its target consumers and buyers in a tangible and systematic manner.