Case Scenario
The Ski Pro Corporation, which produces and sells to wholesalers a highly successful line of water skis, has decided to diversify to stabilize sales throughout the year. The company is considering the production of cross-country skis.
After considerable research, a cross-country ski line has been developed. Because of the conservative nature of the company management, however, Minnetonka’s president has decided to introduce only one type of the new ski for this coming winter. If the product is a success, further expansion in future years will be initiated.
The ski selected is a mass-market ski with special binding. It will be sold to wholesalers for $80 per pair. Because of availability capacity, no additional fixed charges will be incurred to produce the skis. A $100,000 fixed charge will be absorbed by the skis, however, to allocate a fair share of the company’s present fixed costs to the new product.
Using the estimated sales and production of 10,000 pairs of skis as the expected volume, the accounting department has developed the following cost per pair of skis and bindings:
- Direct Labour: $35
- Direct Material: $30
- Total Overhead: $15
- Total: $80
Ski Pro has approached a subcontractor to discuss the possibility of purchasing the bindings. The purchase price of the bindings from the subcontractor would be $5.25 per binding or $10.50 per pair. If the Ski Pro Corporation accepts the purchase proposal, it is predicted that direct labour and variable-overhead costs would be reduced by 10% and direct-material costs would be reduced by 20%.
Ski Pro Corporation to make or buy the bindings
Ski Pro should determine the financial cost associated with the buying decision and compare it with the costs calculated by the accountant to make the decision. The lower cost should be chosen. In computing the cost associated with buying, there is one incremental cost because of the decision. This is the $10.5 charged by the supplier for a pair of bindings. The cost of making the skis will also reduce by the estimated cost of making the bindings. The accountant should subtract this amount from the total. Therefore, as shown in the excel sheet, the total cost of the ski when the bindings are bought is cheaper by $0.5. If Ski Pro is making 10,000 units, it will save $5,000 by buying the bindings.
Decision: Ski Pro should buy the bindings.
The maximum purchase price acceptable to the Ski Pro Corporation for the bindings
The maximum purchase price should be determined by the opportunity cost of manufacturing the Bindings (Horngren, Sundem, & Schatzberg, 2010). If Ski Pro buys the bindings, it will save on Labour, materials, and overheads. These savings should be the maximum price it is willing to pay.
The cost savings are $3.5 for direct labour, $6 for direct material and $1.5 for overheads. Therefore, Ski Pro should not pay more than $11 for the bindings, as it would be cheaper for the company to manufacture its bindings.
Under the aforementioned circumstances, should the Ski Pro Corporation make or buy the bindings?
Ski Pro’s goal is to sell 30,000 units by the end of the year. Unfortunately, this is not certain since the product is new in the market (Jones, 2008). Therefore, in making this decision, Ski Pro should consider the worst-case scenario, i.e., if it sells 12,500 units.
If the supplier maintains the proposed price of $10.5, and Ski Pro incurs an extra unit cost of $0.8 per unit for the 12,500 units, the company will save $16,250 by buying the bindings.
Decision: Ski Pro should still buy the bindings.
Qualitative factors the Ski Pro Corporation should consider in determining whether they should make or buy the bindings
There are several qualitative factors that Ski Pro should consider when deciding whether to make or buy the bindings. First, Ski Pro should consider the novelty or originality of the bindings. If they are a special type of bindings that create a competitive advantage for the company, then outsourcing their production might be detrimental. This is because there is a risk that a competitor may get the information about the bindings from the subcontractor and copy the design. This will lead to a loss of competitive advantage on Ski Pro’s part.
Secondly, Ski Pro should consider the reliability of this proposed supplier. The supplier needs to supply the bindings on time since they are needed in the Ski making process. If the supplier delays, yet Ski Pro have an urgent order, the company could lose a lot of revenue. The prospective customer may opt to purchase from another supplier who delivers on time.
Thirdly, Ski Pro should consider the length of contracts with the proposed supplier (Jones, 2008). This factor is important because the bindings are intended for a product that is new in the market. If the product succeeds, Ski Pro will continue manufacturing them. If it fails, Ski Pro may need to exit the market in a hurry to cut losses. Thus, in such a scenario, a supplier with long-term contracts that are irrevocable might turn out to be a liability.
Finally, Ski Pro should consider the logistics of the delivery of bindings. The new supplier may be cheaper by $0.5 but requires Ski Pro to collect the bindings from their premises. Ski Pro can avoid this inconvenient process by manufacturing the bindings.
References
Horngren, C. T., Sundem, G. L., & Schatzberg, J. (2010). Introduction to Management Accounting. London: Person Education.
Jones, M. (2008). Management Accounting: An Introduction. Chicago: John Wiley and Sons.