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BUSINESS ACCOUNTING FINANCE-2

TERM PAPER PROJECT REPORT


ON


RELEVANT COSTS OF OUTSOURCING DECISION


BY
KOTA.ANUSHA(131249)
A.HARIKA(131250)
K.ASHRITHA(131251)
K.SWETHA MOUNIKA(131253)










RELEVANT COST:
Relevant cost is also called Avoidable cost or Differential cost. It is a cost that differs between
alternatives being considered. It is often important for businesses to distinguish between relevant
and irrelevant costs when analyzing alternatives because erroneously considering irrelevant costs
can lead to unsound business decisions. Also, ignoring irrelevant data in analysis can save time
and effort. Non-cash items, such as depreciation and amortization, are frequently categorized as
irrelevant costs, since they do not affect cash flow
.

Two common types of irrelevant costs are sunk costs and future costs that do not differ between
alternatives. Sunk costs are unavoidable because they have already been incurred. Future costs
that do not change between alternatives are also essentially unavoidable with respect to the
alternatives being considered.
Example:
A construction firm is in the middle of constructing an office building, having spent $1 million
on it so far. It requires an additional $0.5 million to complete construction. Because of a
downturn in the real estate market, the finished building will not fetch its original intended price,
and is expected to sell for only $1.2 million. If, in deciding whether or not to continue
construction, the $1 million sunk cost were incorrectly included in the analysis, the firm may
conclude that it should abandon the project because it would be spending $1.5 million for a
return of $1.2 million. However, the $1 million is an irrelevant cost, and should be excluded.
Continuing the construction actually involves spending $0.5 million for a return of $1.2 million,
which makes it the correct course of action.
A managerial accounting term that is used to describe costs that are specific to management's
decisions.The concept of relevant costs eliminates unnecessary data that could complicate the
decision-making process.

A few key points about outsourcing decisions should be noted:

1. There are no incremental revenues in outsourcing decisions. The decision is whether to
expend costs internally to produce or pay an outsider to produce. Just because a company
chooses to outsource does not mean it automatically changes its selling prices.






2. Incremental costs include:

A. Variable costs of production

B. Avoidable fixed costs, i.e., the fixed costs that wont be incurred if the 'buy' decision is
made, or the costs that will be avoided if a particular decision is made. These are the costs that
will avoided if the product is NOT produced internally.

C. Cost savings that occur as a result of outsourcing versus insourcing. For example, it a
company decides to not manufacture a product, it will save various manufacturing costs
including:

1. Direct labor costs - The labor production costs of producing a product that can be
directly traced to particular products, such as assembly costs.
2. Direct materials costs - The materials used to produce a product that can be directly
traced to a particular product, such a parts, wheels, and components.
3. Variable overhead costs - The indirect variable costs related to production that exist
only because of production, such as factory janitor wages, factory supplies, oil for
production machines, etc.
4. Fixed overhead costs, but only if avoidable. While fixed costs in total remain the same
no matter what level of production, most are not committed and will continue to be costs
to the company even if production is curtailed. . Some fixed costs may be eliminated,
such as production supervisor's salary or rent on factory space that can be terminated.
D. Any opportunity cost that may occur if the company outsources instead of producing
internally. These costs are amounts given up when a particular course of action is chosen. For
example, if a company decides to outsource, it can rent out its manufacturing space to generate
rental revenue. The revenue is a cash inflow if the company outsources, but is an amount given
up if the company chooses to insource.

Making the Decision:

If incremental cost savings are less than incremental costs, the product should continue to be
insourced.

If incremental cost savings equal incremental costs, qualitative factors must be used to make the
appropriate decision.

If incremental cost savings are greater than incremental costs, the product should be outsourced.

Regardless if the choice is to outsource or insource, a company should always consider the
'touchy-feely' aspects of decision making effects. These include employee morale, goodwill to
the community, environmental effects, feasibility, resource availability, etc.


Make-or-Buy Decisions Example:
Bismark Co. also manufactures bath accessories. Management is considering producing a part it
needs or buying a part produced by Towson Co. for $0.55.
Bismark Co. has the following costs for 150,000 units of
Direct materials $ 28,000
Direct labor 18,500
Mixed overhead 29,000
Variable overhead 15,000
Fixed overhead 30,000
Total $120,500
Mixed overhead consists of material handling and setup costs.
Bismark produces the 150,000 units in 100 batches of 1,500 units each.
Total material handling and setup costs equal fixed costs of $9,000 plus variable costs of $200
per batch.

What is the cost per unit?
$120,500 150,000 units = $0.8033/unit

Should Bismark Co. manufacture the part or buy it from Towson Co.?
Bismark Co. anticipates that next year the 150,000 units of Part #2 expected to be sold will be
manufactured in 150 batches of 1,000 units each.

Variable costs per batch are expected to decrease to $100.
Bismark Co. plans to continue to produce 150,000 next year at the same variable manufacturing
costs per unit as this year. Fixed costs are expected to remain the same as this year.

What is the variable manufacturing cost per unit?
Direct material $28,000
Direct labor 18,500
Variable overhead 15,000
Total $61,500
$61,500 150,000 = $0.41 per unit
Expected relevant cost to make Part #2:
Manufacturing $61,500
Material handling and setups 15,000*
Total relevant cost to make $76,500
*150 $100 = $15,000
Cost to buy: (150,000 $0.55) $82,500
Bismark Co. will save $6,000 by making the part.
Now assume that the $9,000 in fixed clerical salaries to support material handling and setup will
not be incurred is purchased from Towson Co..


Should Bismark Co. buy the part or make the part?
Relevant cost to make:
Variable $76,500
Fixed
9,000
Total
$85,500
Cost to buy: $82,500
Bismark would save $3,000 by buying the part.

An Atlanta bakery has offered to supply the in-flight desserts for 21 each.
Here are Worldwides current cost for desserts:










Not all of the allocated fixed costs will be saved if Worldwide purchases from the outside bakery.







If Worldwide purchases the dessert for 21, it will only save 15 so Worldwide will have a loss
of 6 per dessert purchased.


Variable costs:
Direct material 0.06 $
Direct labor 0.04
Variable overhead 0.04
Fixed costs:
Supervisory salaries 0.04
Depreciation of equipment 0.07
Total cost per dessert 0.25 $
Cost per
Dessert
Savings from
Outsourcing
Variable costs:
Direct material 0.06 $ 0.06 $
Direct labor 0.04 0.04
Variable overhead 0.04 0.04
Fixed costs:
Supervisory salaries 0.04 0.01
Equipment depreciation 0.07 -
Total cost per dessert 0.25 $ 0.15 $