Sometimes paying another company to make the product — outsourcing — is more profitable for a company than making the product in its own factory is. Although news reports tend to focus on outsourcing to other countries, outsourcing actually refers to any time you pay another company to do something that you used to do yourself — regardless of where the actual work gets done.
A decision to outsource focuses strictly on expenses and should not affect revenues. Therefore, to make an outsourcing decision, you compare the cost of making a product with the cost of paying another company for it. Choose whichever option is less costly.
Suppose that the fictional Red Socks company produces a line of socks called Duds. Managers project that making 50,000 Duds this year will cost $150,000.
Royals Corp. is willing to make and sell Duds to Red Socks for just $2.50 per unit. This option reduces Red Socks’s fixed overhead costs by 90 percent, to $6,000. To decide whether to outsource the product to Royals, compare Red Socks’s costs under both the make and the buy scenarios. Remember to focus only on incremental costs — costs that change depending on which alternative you choose. Ignore any other costs or revenues.
Multiplying Royals’ $2.50 price per unit times 50,000 units, Red Socks knows it would need to pay $125,000 to outsource Duds. Now compare the two scenarios. As shown there, direct materials, direct labor, and variable overhead all disappear if Royals takes over production. However, Red Socks still needs to pay $6,000 for fixed costs, and, of course, pay $125,000 to Royals.
This analysis indicates that making Duds would cost Red Socks $150,000, while it can pay just $131,000 to outsource this product, saving $19,000.
When making decisions to outsource, be careful to consider opportunity costs, or how you can lose money by choosing one alternative over another. By outsourcing the money-losing alternative, you may be able to use your limited capacity to produce a more profitable product.
When faced with an outsourcing decision, think about qualitative factors that are difficult to measure in dollars and cents. For example, outsourcing may adversely affect product quality, customer satisfaction, or corporate image.