- 20 Marks
Question
Divine Grace (DG) Limited currently produces “Part-2011” internally but has received an offer from KK Plc to outsource the production. The offer is for 1,000 units at N100 per unit for the next five years. The cost accountant provides the following cost breakdown for internal production of 1,000 units:
| Cost Components | Amount (₦) |
|---|---|
| Direct materials | 44,000 |
| Direct production labour | 22,000 |
| Variable production overhead | 14,000 |
| Depreciation on machine | 20,000 |
| Product and process engineering | 8,000 |
| Rent | 4,000 |
| General overheads | 10,000 |
| Total | 122,000 |
Additional information:
- The machine used exclusively for “Part 2011” was acquired last year for ₦120,000 and has a useful life of six years with no residual value.
- The machine could be sold today for ₦30,000.
- Product and process engineering costs will cease after one year if outsourced.
- Rent savings from storage use if “Part-2011” production stops is ₦2,000.
- General overheads are fixed and not allocated to “Part-2011” if outsourced.
- Assume a required rate of return of 12%.
Required:
a. Should DG Limited outsource “Part 2011”? (10 Marks)
b. What maximum price should KK Plc quote for 1,000 units to make DG indifferent between outsourcing and internal production? (5 Marks)
c. What non-financial factors would favor internal production over outsourcing? (5 Marks)
Answer
a) Outsourcing Cost
Decision: Produce internally
The company should continue to produce “Part 2011”
b) NPV =N330,433 – N317,240= N13,193
Sensitivity of the quoted price
This means that the unit price should not reduce more than
N100 – (N100 x 3.66%)
= N100 – N3.66 = N96.34
c)
Non-financial factors favoring internal production:
- Labor Union Concerns: Outsourcing may cause job losses, leading to potential conflicts with labor unions.
- Quality Control: Maintaining high quality standards may be easier with internal production.
- Delivery Scheduling: Internal production ensures better control over delivery times.
- Continuity of Supply: Given that “Part-2011” will be needed for five years, it might be strategically important to keep control of production.
- Tags: Fixed Costs, Make or buy decision, Non-Financial Factors, Outsourcing, Penalty, Pricing, Variable Costs
- Level: Level 2
- Topic: Decision-making techniques
- Series: NOV 2021
- Uploader: Kwame Aikins