Let's consider another decision then a manager might face.
The possibility of outsourcing,
part of a process to a supplier.
This is sometimes called a make or buy decision,
because we're considering whether to make part or all of
the product or to buy it from someone else who makes it.
Let's assume that the T-shirt maker is expecting demand for
3000 additional deluxe T-shirts in the coming year.
The company has the capacity to handle the additional demand.
But a potential supplier has offered to make that 3000 T-shirts for
$11 per shirt which the T-shirt maker would then sell.
Recall our decision making framework.
First, we define the decision to be made.
That decision is whether to make or buy the 3000 deluxe T-shirts.
Second, we identify the alternatives.
There are two alternatives here.
We can make the T-shirts or buy them from the supplier.
In other words, outsource them to another company.
Third, we gather the information relevant to making the decision.
But what information is there?
The additional revenues and additional costs that each of these alternatives generates.
Then after an analysis,
we can evaluate and decide which alternative to choose.
So we have two alternatives.
Alternative one is to make the T-shirts,
and alternative two is to buy the T-shirts from the supplier.
Note that the additional 3000 T-shirts will generate additional revenues,
but those revenues are the same whether we make or buy
so they are not relevant to the decision.
The additional T-shirts will cause the company to incur additional costs and
those costs will differ depending on whether
the company makes the T-shirts or buys them from the supplier.
So the difference in the cost between the two alternatives is relevant to the decision.
The difference in the cost will inform us in making our decision,
and we would choose the alternative that generates more profit.
Now, suppose we obtain information from
the financial accounting system regarding the cost of making the deluxe T-shirt.
Direct material is five dollars,
direct labor three dollars,
manufacturing overhead 5.50, non-manufacturing overhead three dollars,
for a total cost of $16 and 50 cents.
Now at first, we might be tempted to use information obtained
directly from the financial accounting system
without any modifications to do our analysis.
We might start by quantifying the revenues associated with each alternative.
However, remember those revenues will be the same regardless
of the decision about whether to outsource the making of the T-shirt.
As a result, they're not relevant to our decision,
and we'll ignore them for the purposes of this decision.
Now, let's look at the costs.
Recall that the total cost for the deluxe T-shirt is 16.50.
If we used that information and assumed that we would
incur a cost of 16.50 for each T-shirt to make the shirts,
it seems more attractive to outsource the shirt.
Because we would pay the supplier only $11 per shirt.
But remember that some of the 16.50 per unit is variable and some is fixed.
The fixed cost will remain the same whether we make or outsource the T-shirts.
So let's go back to our cost data.
Let's identify the variable cost and
the fixed cost and then we'll rearrange the data again.
According to the cost behaviors,
so that it looks like this.
Now let's use that information to do our analysis.
If we make the shirts,
it looks as if we will incur variable costs of
nine dollars and 27 cents per shirt to do so.
And if we outsource,
we incur $11 dollars per shirt.
But there's something else in these variable costs that we need to think about.
Consider this non-manufacturing overhead of 80 cents.
That selling costs which we would incur if we make the shirts,
because we'd pay a commission to sell them,
and we incur if we buy a shirt because we also pay a commission to sell.
Since we incur the same amount under both alternatives,
it is not relevant to the decision either so we can leave that out of the analysis.
And the variable cost of making sure that's relevant to
the decision is 8.47 not 9.27.
And then in addition,
under both alternatives, we incur the same amount of fixed cost.
So they're not relevant to our decision,
and we're going to ignore them in making that decision.
So our profit would be $7590 lower if we choose alternative two,
buying the shirt from the supplier.
So, we should make them.
Luann J. LynchAlmand R. Coleman Professor of Business Administration
