Outsourcing is a hot topic in business right now. Outsourcing is when a company decides to purchase a product or service from another company rather than make the product or perform the service itself. Many companies outsource components or even their entire product to another manufacturer. When companies make the decision to outsource, there are a lot of considerations. In this post, we will look at the quantitative factors that should be considered when making outsourcing decisions. Don’t forget that there are many qualitative factors such as quality and customer experience that should also be considered as part of the final decision.
The quantitative factors for make or buy and outsourcing decisions are very similar to the factors considered for keep or drop decisions. Here are some factors you should consider:
1. Compare the variable costs to the outsourced price
With make or buy decisions, we will once again use a contribution margin approach. Separate variable product costs from fixed product costs. How do the variable costs of producing the product compare to the cost of purchasing the product from another company. At first glance, it may appear that the cost of the outsourced product is higher because the variable costs of making the product are lower. However, all costs should be considered.
2. Can fixed costs be reduced if production is outsourced?
Typically, fixed costs are the determining factor in outsourcing decisions. When fixed costs are avoidable, typically the company can save money by outsourcing. However, when fixed costs cannot be avoided, the company is paying to have the product made at a higher cost than the variable costs, plus it is still incurring all of the fixed costs it would have had if the product was still being made in-house. Look to see which, if any fixed costs can be reduced or eliminated.
Once you have identified the costs that cannot be eliminated, those costs are irrelevant to your decision. Remember that relevant costs are costs that differ among the alternatives. Therefore, if a fixed cost will be paid whether or not the company outsources, it is irrelevant. When calculating the current cost to make the product, add any fixed costs that can be eliminated to the variable costs identified in step 1. This total is the controllable cost. Compare this cost to the outsource cost. If the controllable cost is lower than the outsource cost, the company should consider continuing to make the product. If the controllable cost is more than the outsource cost, it might be wise to outsource.
3. Are there alternative uses for freed capacity?
Similar to keep or drop decisions, companies should look for ways to use freed capacity. If the company decides to outsource a component, will that free up space and manpower to make more units of the primary product? Additional units means additional revenue or other ways to minimize costs. For example, maybe the company is paying for a lot of overtime because of space limitations. By outsourcing a component, that frees up space and labor, allowing the company to reduce overtime. Idle capacity means costs being paid without the potential for revenue generation. Companies should look to minimize capacity that is not in use.
If there are no alternative uses for the freed capacity and fixed costs cannot be reduced, it most likely does not make sense to outsource. Outsourcing should only be used if overall costs can be reduced and if there are no qualitative factors that outweigh the cost savings.
One type of short-term decision that businesses frequently have to make is whether or not to accept special order requests from customers. A special order is an order that the company did not anticipate when developing its budget for the year. Therefore, this is an additional opportunity to generate revenue above sales goals. Special orders typically request a lower price than normally offered and/or might include additional costs. Often students get caught up in the lower price or lower contribution margin and want to disregard the order immediately. However, if the order will bring in additional profit, the order should be considered.
When faced with a special order decision, a company should consider the following three items:
1. Does the company have the excess capacity to fulfill this order?
Remember that a special order is an order that the company did not expect. The company must make sure that there is excess capacity to fill this order without harming the original plan developed for the year.
2. Will the order be profitable?
Typically, a special order will have a reduced price and/or additional costs. Will the price be high enough to cover the incremental costs associated with the order. Think back to overhead allocation. When overhead allocation rates were developed at the beginning of the year, they were based on the planned production. These special orders are in addition to the planned production. Therefore, fixed overhead would not be applied to these jobs. This allows the company to make the products needed for the special order at a reduced cost. Although the price might be lower, the company may be able to achieve profit on the job.
3. Will the order affect planned sales, now or in the future?
The company must insure that the special order will not hurt other sales. It is important to make sure that the customer requesting the special order does not compete with existing customers or the company itself, which would result in decreased sales at regular prices. Special orders can also lead to unhappy existing customers if they find out about the special deal you gave someone else. Careful consideration must be made when accepting special orders to protect current and future profits.
Identify the relevant costs
In order to identify the relevant costs associated with a special order decision, we must look at the existing costs to determine which costs will be paid if the order is accepted. Previously incurred fixed costs are never relevant. The only fixed costs that should be considered are fixed costs that are incurred because of the special order. Then consider your variable costs. Are there any variable costs that will not be paid with this special order? Sometimes variable selling costs are excluded from the calculation because no sales commission will be paid on the order. These savings can help decrease the cost and increase the profitability of the job.
Carefully read the problem to ensure you have identified the relevant and irrelevant costs properly.
Should the company accept the job?
Typically in problems you will do in class, you will only consider the quantitative factors. Use the contribution margin approach to calculate if the job will generate profit or loss:
1. Calculate the contribution margin per unit
Calculate the contribution margin (price – variable costs) per unit for the special order. Exclude irrelevant costs from the calculation.
2. Calculate the total contribution margin
Multiply the number of units in the special order by the contribution margin per unit.
3. Subtract any incremental fixed costs from the contribution margin to determine profit or loss
If there are any incremental fixed costs, subtract those costs from the contribution margin. If there are no incremental fixed costs, the contribution margin is all profit.
4. Determine if you should accept the job
If there are no extenuating qualitative issues, accept the job if it will generate additional profit. If there is a loss on the job, do not accept the job.
These problems are not difficult. The hardest part is to identify the irrelevant costs and remove them from your calculations. Use what you have learned about contribution margin to determine if you have profit on the special order.
Special Order Decision Making
The contribution margin income statement is a very useful tool in planning and decision making. While it cannot be used for GAAP financial statements, it is often used by managers internally.
The contribution margin income statement is a cost behavior statement. Rather than separating product costs from period costs, like the traditional income statement, this statement separates variable costs from fixed costs.
The basic format of the statement is as follows:
Variable costs, no matter if they are product or period costs appear at the top of the statement. Fixed costs are treated the same way at the bottom of the statement. It is helpful to calculate the variable product cost before starting, especially if you will need to calculate ending inventory.
Let’s run through an example to see how the income statement is constructed. We will use the same figures from the absorption and variable product cost post.
The first thing to remember about any income statement is that the statement is calculated based on the amount of product sold, not the amount of product produced. Therefore, this income statement will be based off the sale of 8,000 units.
To calculate sales, take the price of the product and multiply by the number of units sold.
Sales = Price X Number of units sold
Sales = $100 X 8,000
Sales = $800,000
Next, we need to calculate the variable costs. In the absorption and variable costing post, we calculated the variable product cost per unit.
This covers the product costs, but remember we must include all the variable costs. There is also $5 of variable selling cost that should be included. Multiply the total variable cost per unit by the number of units sold.
Total variable cost = Variable cost per unit X Number of units sold
Total variable cost = ($44 + $5) X 8,000
Total Variable Cost = $392,000
Contribution margin is the amount of sales left over to contribute to fixed cost and profit. Contribution margin can be expressed in a number of different ways, including per unit and as a percentage of sales (called the contribution margin ratio). In the contribution margin income statement, we calculate total contribution margin by subtracting variable costs from sales.
Total contribution margin = Sales – Variable costs
Fixed costs include all fixed costs, whether they are product costs (overhead) or period costs (selling and administrative). One thing that causes the contribution margin income statement and variable costing to differ from the traditional income statement and absorption costing is the fact that fixed overhead is treated as if it were a period cost. All fixed overhead is expensed in the period it is incurred. Under absorption costing, fixed overhead is attached to each unit. Therefore if there are units that are not sold, a portion of the fixed overhead ends up in inventory. That is not the case when using variable costing.
Add fixed overhead and fixed selling and administrative to calculate total fixed cost.
Total fixed cost = Fixed overhead + Fixed selling and administrative
Total fixed overhead = $48,000 + $112,000
Total fixed overhead = $160,000
Last step: subtract fixed costs from contribution margin to calculate operating income.
The contribution margin income statement is all about behavior. Remember the format and ignore the traditional (absorption) income statement. Most students that have trouble with this statement try to relate it back to what is happening on the traditional income statement. Throw out what you know about the traditional income statement when doing the contribution margin income statement. Focus on the format of this statement and you should be fine.
The contribution margin income statement
There are two major costing methods used for creating income statements in managerial accounting: absorption costing and variable costing. These two methods vary based on the way that fixed overhead is applied to the product cost. Product cost includes direct materials, direct labor, and overhead. These are the costs that are included in cost of goods sold and inventory. Only these costs can be included in inventory.
Absorption costing is what you probably think of when you think of product costing. Since the beginning of your managerial accounting course, you have been told that product cost consists of direct materials, direct labor, and overhead. Since we have introduced cost behavior into the course, we know that overhead can be either variable or fixed (direct materials and direct labor are variable costs).
Under absorption costing, we are going to take into account all of the variable product costs and absorb the fixed overhead into the cost of the product.
Let’s look at an example.
Here is some basic cost information for a business. What information is important when we are calculating product cost using absorption costing?
Direct materials, direct labor, variable overhead, and fixed overhead should all be included in the cost of the product using absorption costing. Direct materials, direct labor, and variable overhead are already expressed in per unit figures but fixed overhead is not. We must allocate the fixed overhead to each of the units.
There are two figures we are given: units produced and units sold. Which do you think we should use? You want to make sure that fixed overhead is allocated to all of the units. Therefore, you should use units produced. Using units produced will allow overhead to be allocated to all of the units, those that were sold and those that are still remaining in inventory.
Allocate overhead by dividing the fixed overhead by the number of units. This will give us fixed overhead per unit.
Fixed overhead per unit = $48,000/10,000 units
Fixed overhead per unit = $4.80 per unit
NOTE: Fixed overhead per unit will only be $4.80 per unit when 10,000 units are produced. This is not a variable rate. The rate is not constant. If the company produced 20,000 units, the rate would be $2.40 ($48,000/20,000). This rate will fluctuate as production changes.
With the fixed overhead now expressed as a per unit figure, we can add it to the direct materials, direct labor, and variable overhead to calculate the absorption cost per unit. Under absorption costing, the cost per unit is $48.80.
Absorption costing is required by GAAP and must be used on the external financial statements.
Variable costing is just another form of product costing. As the name implies, only variable product costs are used to calculate the cost per unit of a product. Therefore, we will not include any of the fixed overhead in the cost of the product.
It might be tempting to include variable selling cost because it is also a variable cost, but remember that selling cost is a period cost and is expensed when incurred. Only include product costs in the calculation: direct materials, direct labor, and variable overhead. Notice that the product cost is lower because no fixed overhead is included.
In the next post, we will look at the traditional (absorption) income statement and the contribution margin (variable) income statement.