Capital budgeting analysis of in-house versus outsourced manufacturing

Buy or Sell

In making this calculation, the first thing to remember is that overhead is never to be included in a capital budgeting decision. If management "insists," that is too bad for them. Only costs incremental to the decision at hand should be included. That policy will not be violated for any reason. The nature of the indirect labor is not known. If this is an overhead cost, it should be omitted, but it might be incremental labor. Since we do not know this we should take a conservative approach and include it.

The following are the results of a net present value calculation on the two options:

Taiwanese Supplier

Forecasted Demand

Cost

Shipping

Add Inventory

Admin

Total cost

23240

34740

57740

PV

20208.7

26268.43

37964.99

NPV

84442.11

Producing in-house

Fixed Cost

10000

DM

10000

15000

25000

DL

13500

22500

Ind labor

Benefits

Engineering

30000

0

0

62300

33450

55750

PV

54173.91

25293.01

36656.53

NPV

116123.4

Based on this calculation, the in-house option costs more over the three-year life of the project. As such, the company should purchase from the Taiwanese supply. Just remember to make the contract in USD so that the supplier bears the foreign exchange rate risk.

Role-Playing: Seller/Trader

The jacket vendor's cost is $30, which equates to 200,000 of local currency. The exchange rate is therefore 6666.66 to 1.

The buyer has a total of $115 worth of currency, $100 in dollars and $15 in local. The buyer is getting a deal no matter what, but will want to bring the price down a bit.

The seller is also getting a deal no matter what, since the cost of a jacket is $30 or 200,000 local. From the seller's perspective, a discount is required to sell in local currency, as hard currency has more stable value. The buyer likely also prefers to use hard currency, rather than losing on the currency exchange. There is room for both to find common, profitable ground. The seller will find other customers and would therefore not accept less than 300,000. The common ground for a deal is massive, there should be no problems.

Role Playing: Supplier Decision