This is part 5 in our short-term business decisions series and here we're
going to be discussing outsourcing and process further decisions. So first we'll
talk about outsourcing and things that management need to think about when
deciding whether to outsource. How do our variable costs compare to outsourcing
costs? Remember fixed costs typically you can't get rid of. In some instances you
can. So variable costs are what we really focus on. Variable costs are created when
we produce a product, so if we outsource those variable costs are likely to
disappear. Are the fixed costs really avoidable if we outsource? So for example,
rent on a manufacturing building. Well we may not need the manufacturing building
anymore if we outsource, so that would be an avoidable fixed cost that we could
get rid of if we outsourced. What can be done with freed capacity? So we have to
think about our opportunity costs. So what are we foregoing by not
outsourcing? So for example if we own the building, if we outsourced, we could rent
the building out. So by not outsourcing, we are foregoing the rent that we could
be earning on our building. That's an opportunity cost. So let's look at the
decision rules of whether we should outsource or not. If the incremental cost
of making a product exceed the incremental costs of outsourcing
then we should outsource. That means it costs more for us to make it than for us
to buy it somewhere else. If the incremental cost of making the
product are less than incremental cost of outsourcing, or buying it from
somewhere else, then we do not outsource.
Let's also look at the decision whether we should sell a product as it is or
process it further. So with, just as with all these other decisions where we're
looking at there are things management must consider. For example, how much
revenue is generated if we sell the product as it is and compare that with
how much revenue is generated if we sell the product after processing it further?
Keep in mind typically if you process a product further there's going to be
additional costs involved. And how much will it cost to process the product
further? Now let's look at the decision rule. So should we sell as is or process
further? If the extra revenue from processing further exceeds the extra
cost of processing further then we should go through with processing the
product further. If the extra revenue from processing further is less than the
extra cost involved in processing further then we should sell as is and do
not process the product further. Let's look at an example with gasoline. So we
see here that we have $125,000 in sunk cost for producing 50,000 gallons of
regular gasoline. We have two choices: we can sell as is or we can process further.
If we sell as is, we will have $190,000 in sales revenue. If we process further,
we'll have $200,000 in sales revenue. There's no additional cost if we sell as
is. Looking straight on here well we should, we should process further because
we're getting $10,000 more in revenue but remember what we said earlier: there's
typically a cost involved when you process a product further just as in
this case there is a cost involved. With sale as is, there is not a cost involved.
However with processing further, we would need to pay $7,500 in additional costs to
process the product further. So now we have to take in consideration that
there's $10,000 more in revenues if we process further, but
there's also $7,500 in additional costs of processing
further. However since $10,000 is higher than $7,500 then
we should process the product further.