Outsourcing and make-or-buy decisions In the example in Chapter 10, even though the number of units remains the same, the total purchasing, receiving and setup costs increase because the number of batches is doubled. This illustrates why reduction in setup time is key as firms move to small-batch production and JIT delivery systems. Opportunity costs, outsourcing and capacity constraints One general approach to outsourcing decisions is the following Maximum we Incremental Opportunity cost would pay = cost + of insourcing outlay cost) This formula tells us how much we can pay the outside supplier and still make a profit as if we produced the number of units ourselves. We are willing to pay at least the incremental cost of insourcing (i.e. our outlay cost. If facilities would otherwise be idle, the opportunity cost of insourcing is zero because there is nothing better to do with the plant. In the example, opportunity cost is not zero because the plant can be used to produce another product. The incremental outlay cost is €150,000 and opportunity costs are €25,000 (see Panel B of Exhibit 10.7). The maximum that should be paid to the outside supplier is €175,000/10,000 = €17.50 per unit. At least two factors help explain why some companies have had high stock levels. First, since the cost of capital tied up in stock is not reported by the accounting system, management may never see this information. Second, purchasing managers are frequently rewarded for favourable price variances, so they maybe tempted to purchase large quantities to obtain a quantity discount.
