Exercise 2 (Chapter 13)-Outsourcing Decision Smith Bicycle Manufacturing Company

Question

Exercise 2 (Chapter 13)-Outsourcing Decision Smith Bicycle Manufacturing Company currently produces the handlebars used in manufacturing its bicycles which are high-quality racing bikes with limited sales. Smith produces and sells only 10,000 bikes each year. Due to the low volume of activity, Smith is unable to obtain the economies of scale that larger producers achieve. For example, Smith could buy the handlebars for $31 each; they cost $34 each to make. The following is a detailed breakdown of current production costs. Unit Cost Total Unit Level Costs Materials Labor Overhead $16 $160,000 12 120,000 2 20,000 4 40,000 $34 $340,000 Allocated facility-level cost Total After seeing these figures, Smith's president remarked that it would be foolish for the company to continue to produce the handlebars for $34 each when it can buy them for $31 each. Required: Do you agree with the president's conclusion? Support your answer with appropriate calculations

Explanation / Answer

The question is pertainng to the outsourcing decision:

One has to divide the costs into Variable costs and Fixed Costs for decision making. Because, fixed costs should generally be ignored for decision making. These are the type of costs which incurr even if the company does not operate.

Now, in the question

Material- $ 16

Labour- $ 12

Overhead $ 2

All the above stated costs are variable costs. And it totals upto $ 30 per bike produced.

The allocated facility level cost is fixed cost and $ 4 is to ignored for decision making.

Decision:

If the company purchases from the third party, it would have to pay $ 31 whereas, if the company produces on its own, the company need to incurr $ 30. So there is a saving of $ 1 if the company produces on its own.

Hence the company should produce the bikes and the decision of the president is wrong.

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