Steve Rothel Needs to Decide

Steve Rothel needs to decide whether to buy the pipe or to make it. In order to make this decision, he must utilize a number of decision-making criteria. The vice president asked about outsourcing on the basis of cost. However, Krause must consider that this task is highly specialized, and errors in the HVAC system could have disastrous consequences.

In terms of safety, there are two main points to consider. The supplier is able to provide perfectly round pipes, something Krause cannot guarantee. This would reduce the risk of leaks in the welds. Krause's system would therefore have a higher risk. However, that is a known risk. Krause can only take the supplier at its word with respect to the quality of its pipes. If the supplier's pipes are not to the standard as advertised, it is likely that Krause will need to bear the cost of fixing the work. It should be of concern to Rothel that this supplier is willing to offer pipe for $18 when other estimates are $5-10 higher. Such an undercut means that its processes are significantly worse than the competition, or that they have a significant source of competitive advantage, such as economies of scale that it is utilizing to deliver the abnormally low price.

In addition, the supplier can deliver pipes twenty feet long. Krause can only make pipes eight feet long, and would need to use joints in order to extend the lengths of several pipes. If the supplier's claims of quality can be verified, then the pipe length and perfect roundness would give the quality edge to the supplier.

In terms of cost, the supplier is offering $18.10 per linear foot. Krause's cost structure is as follows. The labor cost of a foot of pipe is the $32.60 divided by the eight feet in a pipe, for a total labor cost of $1.086 per foot. Welding gas and welding wire are $0.031 and $0.156 per foot respectively. The steel cost is $4.50 per foot. Overhead costs are not included in the calculation as they are not incremental cash flows. Only incremental cash flows should be included -- arbitrary overhead allocations are irrelevant. Whether made in house or purchased, the pipes cost will eventually contribute to the company's fixed costs, but it is not appropriate to consider this as this stage. The total cost per foot of $5.77.

However, there is a wild card to the costs. The cost of joining two eight-foot pipes to make a longer pipe is $9.78 in labor costs per long pipe. There are "many" of these in the project. It is not known how many, but even if we assume that one of these joints will be required for every two pipes, that only adds $0.62 to the cost of the pipe.

The cost of making the pipe is clearly lower than the cost of buying the pipe. Krause's variable cost of pipe is $5.77, escalating to at most $6.39 per linear foot. The supplier is offering $18 per linear foot.