# MEMORANDUM

MEMORANDUM.

## MEMORANDUM

Let’s pretend you are a junior buyer. Suppose that a make-buy decision is being made for an injection molded plastic part. In other words, do you make it yourself or do you outsource it to a supplier? The fixed costs of making this part are \$200,000. The variable cost to make this part is \$0.40. The lowest bid received from the pool of qualified suppliers is \$0.75 per part. What is the break-even quantity? Hint: It is the point where the total cost to manufacture equals the total cost to purchase. The information below might also help. Please interpret your results. Meaning, what decision should you make based on if you need more or less than the break even quantity? Simply email me your answer. It does not have to be very long.

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“Fixed” Costs do not vary with production (e.g., Building, equipment, interest, advertising, R&D)

“Variable” Costs vary directly with production (e.g., Materials, production, labor, consumable tools)

“Semi-variable” Costs contain both a fixed and a variable component (Energy consumption is one example)

“Total” Costs are the sum of fixed, variable and semi-variable costs

‘Direct’ costs are those costs that can be allocated to specific products

‘Indirect’ costs (overhead) are costs that cannot be specifically identified with a particular product

Although ‘direct’ and ‘indirect’ costs sound a lot like fixed and variable costs, they are not the same thing.

Direct/indirect costs result from the firm’s ability to assign costs to a specific product.

‘Direct’ costs can be “fixed” or “variable”: A supervisor may be paid a salary to supervise the production of one single product—the salary is fixed but directly assignable to the product.

‘Indirect’ costs can be “fixed” or “variable”: The consumption of supplies varies with production, but the costs are not usually applied to specific products.

In industry costs are usually broken down as:
Direct Labor
Direct Materials

Two purposes for a break-even analysis:

1) Determine if production volume is sufficient for a firm to produce a given product

2) Estimate break-even sales level for a supplier to determine how eager they are for new business

To determine the break-even point for the make/buy decision, three pieces of information are required:

1) The fixed costs of producing the product
2) The variable costs of producing the product
3) The purchase price per unit

To calculate the break-even quantity – A graph can be plotted by:

Setting up the graph with total cost as the vertical axis and # of units as the horizontal axis.

Plotting the purchase cost line, which starts at the origin with slope equal to the per unit purchase cost.

Plotting the make cost line, which starts at quantity zero with a total cost equal to the fixed cost, and has a slope equal to the variable cost.

The intersection is the break-even point. Do not do it this way.

This exercise assumes that the Make/Buy decision is based on cost issues and nothing else. We know that the sourcing decision should be based on more than just cost. Other factors influencing the Make/Buy Decision such as: availability of multiple sources, spares, capacity, need for direct control over production or quality, design secrecy, supplier reliability. The Make/Buy decision is a strategic issue because your decision could impact your firm for years to come.

The make or buy decision should be a part of the firm’s strategy development process.

Costs: All relevant costs must be considered in the Make/Buy decision –

Make Option: Delivered purchased materials costs, Direct labor costs, Incremental overhead, Incremental managerial costs, Incremental purchasing costs, Incremental inventory carrying costs(raw material), Incremental capital costs.

Buy Option: Purchase price, Transportation costs, Receiving and inspection costs, Incremental purchasing costs, Inventory holding costs.

Things to consider: Time factor, Must consider entire product life, Must consider changes in future events, Discounting is appropriate, Bids from potential suppliers may be unreliable, RFQ not taken seriously, Buying in, Capabilities lost are not easily regained.

Most firms price their products to generate a satisfactory return on the whole line, that is, the profit margin on each product is different.

If a supplier’s product is high volume and efficiently produced, then using an average profit margin is excessive (from the buyer’s standpoint), and the buyer should be able to negotiate a price that includes a lower profit margin for the supplier.

Here is some help on the Make/Buy HW (if you read this far, this will pretty much give you the answer to the HW) –

It is the point where the total cost to manufacture equals the total cost to purchase. Letting Q be the break-even quantity, we can calculate this as:
200,000 + 0.40Q = 0.75Q
And, with a little algebra
Q = x
So if the company plans to use more than x of these parts, it is cheaper to make them (in general, ignoring a host of other cost issues). So if the company plans to use less than x of these parts, it is cheaper to buy them (in general, ignoring a host of other cost issues).

MEMORANDUM