Let's take a look at a common operational decision in our GnG Landscape setting. Currently, GnG purchases 300 orchids, a type of flower from a local supplier each month. The supplier has recently raised the price to $10 per orchid. Gina, the manager of the floral department, has asked for an estimate of the cost of producing orchids in-house. So essentially, Gina's been buying from an outside supplier and now she wants to decide whether or not she should produce the orchids herself or make the product in-house. So here's some information that Gina has. Two additional employees would have to be hired to produce the orchids in-house. But existing greenhouses, soil and potting supplies could be used to produce the orchids. No other changes to the business would be necessary to start producing the orchids themselves. In terms of predicted costs, the seedlings and fertilizer would be $5 per unit. The planting, watering and supervision labor would be $3 per unit. And the production overhead costs would be $2 per unit. The organization would also allocate administrative overhead costs to the orchids at a $1 per unit. This $5 + $3 + $2 + $1 = $11 total per orchid. Other information available is that half of the production overhead on a per unit basis is based on the orchid line's share of fixed cost for land, greenhouses and production supervisor salaries. And administrative overhead is the orchid line's share of administrative support costs, such as finance, accounting and corporate support. So now let's analyze this decision a little bit more closely. Again, this is a make or buy decision. So, we're focused on costs here for now. One decision or one path would be to continue to buy the orchids from the external supplier, and we know that that comes out to be $10 per orchid. The other option is to produce the orchids ourselves, generically referred to as the make option. And we were told that our costs were going to be $5 for the materials, $3 for the labor, $2 for overhead that had to with manufacturing or production, and $1 that was overhead, that had to do with administrative support. For the report that was provided initially, the cost of making these orchids is $11 per unit. And on the surface, it looks as though it costs us too much or more than what we're currently paying to buy the orchids and so the decision would be to continue to buy the orchids from the external supplier, even though the price has recently gone up. But let's dig a little bit deeper into this situation. First of all, what about the revenues associated with these transactions? We're not just buying the orchids for ourselves, we're turning around and selling them to our customers. Well, let's assume that no matter where we get the orchids, whether we produce them in-house or we buy them from the external supplier, we charge our customers the same. This is an example of a situation where the revenues are irrelevant. They're the same regardless of whether we make or buy the orchids. So therefore, we would exclude from our consideration any consideration of revenues. Those don't differ between our two decisions. Now let's apply that concept by ignoring the revenues, because they're irrelevant to some of these costs. So, looking at the buying of orchids from the external supplier, if we choose to buy the orchids, we'll pay $10. If we choose not to buy the orchids, we won't pay the $10. So the $10 differs between those two alternatives, to buy or not buy. So that $10 we would classify as relevant. On the make side, things are a little bit different. We would look at each of these individual costs to see if they truly differ between our decisions to make or not make the orchids ourselves. So let's think about the information that was provided to us. In terms of the seedlings and the fertilizer and other materials, I would classify that as relevant. We are going to have the $5 charged for materials if we produce the orchids ourselves. If we don't produce themselves, we don't have to spend that $5. So in terms of the relevant column, The $5 is something that I would classify as relevant. The same could be applied to the notion of labor. We would have to hire a couple of additional employees to oversee the orchid. So on a per unit basis that was reported as $3 per unit. If we make the products ourselves, we'll have to hire that labor and pay them. If we don't make the orchids, we won't have to hire that labor. So direct labor is relevant. We were also told that half of the overhead manufacturing was something that was incurring already. These were the fixed cost for production. And so out of the $2 for manufacturing overhead, we're already incurring the equivalent of that one currently. It's just now because we would produce orchids, it would be allocated to those orchids. But really that's not changing the costs that are being incurred by the firm. So out of the $2, we have a dollar portion that is relevant and a dollar portion that is irrelevant. The fixed manufacturing overhead is ignored in this situation because that cost is actually not changing as a result of adding the orchid line and making the orchards inside, in-house. Currently, that dollar is placed and allocated elsewhere to other product lines and if we were to add the orchid line, it's just a reorganization of the existing costs to include some representation on the orchid's financial statements. The overhead admin had to do with finance, accounting and corporate support. And I would assume that none of those costs are really changing as a result of adding the orchid line, to the extent they are, they would be relevant. But in this case, I'm going to assume them away and say that our corporate costs aren't really changing as a result of adding orchids. So that dollar that we would be charged for the orchard line is actually irrelevant. We're already incurring a certain amount of costs, this is just a cost allocation issue that's happening here. So in terms of our revised perspective, and considering just the relevant information, our costs would be the materials, the direct labor and part of the overhead for manufacturing or production. That's 5 + 3 + 1 which comes out to be $9 per unit. The additional $1 from overhead manufacturing and the other $1 for overhead admin, those are costs that are not really changing between decision alternatives. It's just that these are being allocated to the orchids themselves. So really, in essence, it's a cheaper option to make the orchids ourselves, compared to buying them from the external supplier. Just for clarification purposes, let's look at an alternate view of this. Same situation, but really it has to do with what we classified as irrelevant. That overhead manufacturing that was fixed of $1 and the overhead administration of $1 that was being assigned to each orchid is actually already being incurred. We've already incurred that inside of the firm, it's just allocated to other products that currently exist. So really if we were to think about these two options that way, then the buy option is the $10 that we would pay the external supplier + the equivalent of $1 of fixed overhead and another $1 of corporate overhead. Costs that are being incurred, they're just being allocated somewhere else. And in terms of the make option, we would have all of our costs that we would be incurring there. $5 + 3 + 2 + 1. The total for the buy would be $12. That's when we include what it costs us to purchase each orchid as well as the costs that are currently being incurred for fixed overhead and overhead administration but just being allocated somewhere else. And then in the Make option, we already know that the total cost is $11. So when we take into account this irrelevant information, our decision doesn't really change. In essence, Make is still cheaper. It's just that under the old way of looking at it, we weren't aware that there was this additional cost of fixed overhead and overhead administration. So, essentially our decision at the end of the day, based on this profitability measure of costs, is that we should make the orchids in-house. It looks like the cheaper option. Now, let's close this out and think about other issues that we would face in this decision that we have not seen in our profitability focus. One, do you have any other concerns about this decision? Well, first off, I will think about the quality of the product. In terms of quality, we know what we're getting would be external supplier because we will continue to have those transaction over time. But in terms of being able to make the orchids ourselves, the quality might be questionable, might be lower because we're new at growing these orchids or it could be maybe something that we increase the quality of because we're better at producing those units. So we would enter into the strategic consideration of quality and the value of quality is oftentimes very difficult to quantify and incorporate in our financial analysis. The other issue would be opportunity costs. By us going into an orchid line business, are we having to give up anything else that we're currently doing or could do with those resources otherwise? Of course, knowing what that next best alternative is is sometimes difficult to identify. And quantifying things associated with something that we haven't pursued yet, also difficult. Regardless, managers would keep these strategic and non-financial implications in mind as they're using the profitability analysis that we went through to make this decision.
