In many manufacturing operations, a company must decide whether to produce a certain part required in the assembly of its finished products or to buy the part from outside suppliers. If the company is currently producing a part that could be purchased at a lower cost from outsiders, profits may be increased by a decision to buy the part and utilize the company’s own manufacturing resources for other purposes.
For example, if a company can buy for $5 per unit a part that costs the company $6 per unit to produce, the choice seems to be clearly in favor of buying. But the astute. reader will quickly raise the question “What is included in the cost of $6 per unit?” Assume that the $6 unit cost of producing a normal required volume of 10,000 units per month was determined as follows
Assume that a review of operations indicates that if the production of this part were discontinued, all the cost of direct materials and direct labor plus $9,000 of variable overhead would be eliminated. in addition, $2,500 of the fixed overhead would, be eliminated. These. then. are the relevant costs in producing the 10,000 units of the component, part, and we can summarize them as follows:
Out analysis shows that making the part will cost $60,00d per month, while buying the part will cost $78;000. Thus the company will save $18,000 per month by continuing to’ make the part
What if the’ company could have used its production facilities to manufacture a new product line that would increase overall profitability by $25,000 per month? If this were the case, the $25,000 profit would be viewed as the opportunity cost of using the company’s production facilities to manufacture a component part. Obviously, the company should not forego a $25,000 profit in order to save $18,000. Thus, when the opportunity cost is considered, it becomes evident that the company should buy the part and use its production facilities to manufacture the new product.
Joint Product Decisions
Many companies produce multiple products from common raw materials and a shared production. process. Examples include oil refineries, lumber and steel mills, and meat. processing companies. Products resulting from; a shared manufacturing process are termed Joint products, and the manufacturing costs that relate to these products as a group are called joint costs.
In such manufacturing processes, two business issues arise. One is how to allocate joint costs among the various types of products manufactured. The second incremental type of decision is whether some types of products should be processed further to create an even more variable finished good.
Let us first address the’ issue of joint costs. Assume that CharCore mixes together wood chips and pine oil. After joint manufacturing costs of $2,000 have been .. incurred, this mixture separates into two salable products: granulated charcoal and methyl alcohol. How should the $2,000 in joint costs be ~Iocatcd between these products?
Decisions After the Split-Off Point
Once joint products can be separated, they have reached what is called the split-off point. At this point, each product may be sold independently of the other, or it may be processed further.
Again consider CharCore. The company, may sell its charcoal and alcohol after the split-off point without further processing, or it may continue processing either of these , products. CharCore can use the granulated charcoal to manufacture air filters, and the methyl alcohol to make cleaning solvent. The following diagram illustrates CharCore’s options and reflects current sales prices and manufacturing costs:
The decision of whether to sell the charcoal and alcohol or to continue processing ill based on the incremental costs and revenues expected (tj’tc:r the split·uff point. An analysis of these costs and revenues appears as follows
We have merely scratched the surface in discussing the possible kinds of analyse” that might be prepared in making business decisions. Our coverage in this chapter, however, has been sufficient to establish the basic principles that lie behind such analyses. The profitability of a course of action depends on the incremental revenue and expense’. However, opportunity costs may play a major role in the decision.
We also have stressed that, in addition to quantitative information, many non financial factors must be taken into consideration. It would be irresponsible and shortsighted for managers to seek solutions and base decisions entirely on revenue and cost figures. Indeed, most business decisions also require all examination of legal issues, a sensitivity to ethical implications, and anabitirv 10 distinguish fact from opinion. Thus, while incremental analysis is an excellent tool for evaluating alternative .courses of action, managers should not automatically follow the first course of action that holds a promise of increased profitability. Rather, they should always be alert to the possibility that a more satisfactory, and perhaps more creative, solution exists.