Introduction
The case dwells upon a decision, which is to be taken by the Global Positioning System Navigator (GPSN) Manager Wally Wizard at the largest automobile manufacturer in the United States, Behemoth Motors Corp (BMC). The scope of the decision looks at two alternatives: 1) in-house production of 8,000 units of GPSN per months to be installed on the Sports Utility Vehicles (SUV), and 2) outsourcing of this production volume to reasonably new Far East Enterprises (FEE) Company under the terms of two-year contract. There are three critical aspects that should be considered as part of the decision-making process: financial element, risk management and quality management issues. All elements should be equally important for Wally Wizard as the scale and scope of the project demand high investment and long-term commitment.
Information Analysis
One of the critical elements for the decision is the quality assurance as BMC aims to maintain the highest level of its products and preserve the reputation of the company. It was identified that both alternatives, in-house production and outsourcing, will present BMC with the opportunity to maintain the same quality level with only 2% waste and similar lead times for GPSN units. With that in mind, quality management issue will not be further considered in the final decision-making argument.
BMC should consider the reliability of the transportation and communication in case of outsourcing. Based on the reputation of the company and general experience of multinational corporations with China sourcing, it is possible to assume that logistics channels are well established and will not present a significant risk for the project. Additional considerations are related to the currency rates and, given the fact that the contract assumptions are made in US dollars, it is possible to conclude that the costs of outsourcing will not be influenced by the currency fluctuations ((Kimmel, Veygandt and Kieso, 2011).
Risk and Opportunity Cost Analysis
It is evident that, under the existing arrangement, all the raw materials are purchased locally, and there is no commitment in regards to the length of the purchasing contract. The downside of the contract with FEE is the two years commitment that reduces BMC flexibility and creates the risk of higher unit costs in case of direct material cost fluctuation. That said, in case of 15% reduction of the direct material cost the company can dilute the financial benefit of outsourcing (Appendix I). Additional evaluation of the shift between the options outlines that direct overheads, as well as supervisory staff costs, will be zero due to the possibility of reallocation of the headcount to other operational units and projects without any financial implication. One of the major implications on the Human Resource Management (HRM) side is the cost associated with the employee layoff and estimated at a total of USD$ 264,000 for the 4 year period. The assumption that can be made that this fine is to be paid in full in case of outsourcing the production to FEE as the in-house production process started recently.
Additionally, the decision for outsourcing will leave 8,000m2 of unutilized space that is currently included in the total factory costs of BMC. With that in mind, the cost can be considered as sunk and should not be part of the decision-making process for the GPSN alternatives (MH Education, 2013).
Relevant Cost Comparison
Calculations, presented for the existing GPSN production solution outline the total unit cost of USD$425, as opposed to USD$ 400 per unit price from FEE. This cost, however, does not include the average waste of 2%. Given the fact that both alternatives represent the same quality indicators, the unit production cost, accounting for the loss, will be USD$ 434 and USD$ 408. It should be taken into consideration that outsourcing of the production to FEE will allow BMC additional cost saving on the rental costs for the storage facilities that will result in the company´s bottom line improvement through reduction of liabilities. This cost should be considered as an opportunity and could eventually be estimated as an additional saving of USD$ 1.6 per unit under the outsourcing alternative. It is important, however, to understand the impact of the fine that BMC will encounter in case of employee layoff, which can be estimated as USD$ 0,7, based on the assumption that a fine of USD$ 66,000 per annum is divided equally between 8,000 units produced monthly. With that, the comparison of production cost should be made between the current production price of USD$ 425 and USD$ 399 under the outsourcing alternative (Appendix I).
Recommendation and Conclusion
The comparison of two options for GPSN production illustrates that the overall saving that BMC can gain per year by outsourcing the production of the units to FEE is almost USD$ 2.5 million, given the production of a total of 96,000. This saving includes the relevant opportunity and direct costs. One of the major considerations that should build on the decision-making process, however, is a potential risk associated with the variation in direct material costs. Currently, the company benefits from flexibility in its purchasing decisions and high responsiveness to the market need of GPSN units that allow BMC immediate closure of the operations with a total cost of only USD$ 264,000. In the case of the contract with FEE, BMC will create a long term commitment, which involves the risk of losing the above mentioned advantage. Sensitivity analysis demonstrates that the reduction of only 15% in the material costs can totally dilute the cost advantage gained by accepting the contract with FEE (Kimmel, Veygandt and Kieso, 2011).
Based on the above calculations and consideration it is possible to argue that the potential saving, coming from the outsourcing of the GPSN production to FEE is significant, and it is recommended that BMC accepts the offer and shifts the production option to the 3rd party. In spite of the risks, associated with the variation in material costs, it is possible to assume that the cost of direct material will experience variations, but these variations will be marginal in a long run.
Appendix I – Cost Summary and Comments
References
MH Education. (2013). Relevant Cost Presentation. McGraw Hill Online. Retrieved 12 March 2014, http://www.mheducation.ca/college/larson9/olc/olc/graphics/larson9fa_s/ch28/slideshows/sld030.htm
Kimmel P., Veygandt J., and Kieso D. (2011). Financial Accounting. Tools for Business Decision Making. 6th Edition. New York, NY: John Willey and Sons. Print.
