 Hello and welcome to this session. This is Professor Farhad in which we will discuss make or buy decision or sometime it's called insourcing or outsourcing. Think of a company like Apple computers that produces the iPhone. Notice the iPhone has many parts but the process starts with R&D research and development then they design the phone then they have a prototype then they have a list of parts that are needed and Apple will have to decide whether they want to produce those parts themselves or they want to buy the parts from another party and assemble the phone to make the phone ready and available for sale. So whether to make or buy which is called insourcing or outsourcing is what we're going to be discussing in this session. Companies that takes the product from A to Z they are called vertically integrated companies it means they start by research and design all the way till the end. Well there are advantages and disadvantages for vertically integrated companies. What are some of the disadvantages that you can think of? Well for one thing if you are producing the parts well it's a smoother flow of material and parts throughout the company because you you are producing them. Also since you are producing the part you have control of quality because you are controlling every step in the process. You know what goes into each product and you are producing it the way you want to you're not cutting any corners because the product is going that part is going into your product. Also you can enjoy economies of scale. If you produce a lot cost will go down so that could be an advantage but also failure to take advantage of the economy of scales that could be a disadvantage. Simply put if you don't produce enough and you have a high fixed cost to produce that part well you may not take advantage of economies of scale because economies of scale assumes you're going to be producing large volume. Also you could be also losing control of quality and the reason is that's not your specialty that's not what you do on a day-to-day basis therefore the quality may not be good or maybe another company that's what they do every single day and over time they have a better control of quality than you do. Also another advantage of producing or having vertically integrated is if you are producing enough you might be able to sell to outsider and also make profit for the parts. Simply put you produce it for yourself for your own product and you can sell it to an outsider and make a profit on the part itself. But one of the disadvantages if you don't produce it yourself is disruption in supply chain and this happens if you have wars or especially what happened with COVID where companies were relying on suppliers and suddenly they could not rely on suppliers or sometime the parts that you need are located in areas where they're affected by COVID or wars and you cannot get the product to produce it therefore you have a disruption in your own supply chain. So disruption could be on both end you could be producing it and having problem or you could be relying on a third party and having problem as well. Now the best way to illustrate make or buy decision is to actually look at an example with numbers. Now before we look at numbers I would like to remind you whether you are a student or a CPA candidate and this is mostly most likely who you are if you are watching this go step further farhatlectures.com where I have additional resources to accompany your CPA review course or your accounting courses. My product can help you do better in your class or on your CPA exam. If you have not connected with me on LinkedIn please do so take a look at my LinkedIn recommendation like this recording if you're watching like it if it's helping you it will help others like it it will help me as well connect with me on Instagram Facebook Twitter and Reddit. So for the purpose of our example we're gonna be producing or Apple will need to decide whether they need to produce the battery for their iPhone or if they are going to buy it from an outsider. So this is the cost that they need and let's go over the cost for Apple to produce the battery themselves basically to make the product direct material $30 direct labor $50 variable overhead $10 depreciation of production for the equipment $30 supervisor salary $20 general factory overhead $100. So right now it's costing Apple $300 to produce the battery that goes into the iPhone. Now bear in mind that the if they discontinue this if they if they outsource this process they cannot get rid of the production of the equipment there is no resale value it's so specialized and the general factory overhead is unaffected by that decision so it's unavoidable cost it means it has this cost here will have to be reallocated somewhere else and whatever it's going to be reallocated to they're not going to like it but the point is you're not going to get rid of this $100. So the $300 parts is based on 20 000 parts produced each day now an outside supplier came in and offered Apple rather than rather than 300 they can offer them 250 so the supplier said look you buy it from us we'll deliver it right to your production process for $250 the question is should we buy the product or should we keep on producing the product well what how do we solve this problem well we're gonna have to make that decision make or buy we're gonna have two column one is buy and one is make and the buy is easy the order from the outsider is 250 times 20 000 unit so we need $5 million per day if we want to buy it from an outsider and not worry about it what happened if we make it now we have to decide what cost we can avoid if we make it what cost we can avoid well here we can avoid we can avoid direct material 20 000 for 20 000 unit at 90 dollars 1.8 million we can avoid direct labor we don't have to hire those people to make to work on this production process $50 000 times 20 000 unit is a million dollar variable overhead $10 times 20 000 unit we cannot get rid of the depreciation of the equipment because this is basically a sunk cost we still have to depreciate the equipment because we cannot sell it so we have to keep it salaries supervisor salary we can get rid of that $20 per unit on average times 20 000 unit 400 000 we can get rid of this so all these costs the 1.8 million 1 million 200 000 400 000 those are avoidable costs that we can get rid of if we if we if we buy the product the general factory overhead I told you it is not it is not not 10 it's 100 it doesn't matter 100 or 1000 or 10 we can get rid of this because we have to reallocate this somewhere else so if we make the product versus if we buy the product if we buy it's easy it's 5 million if we don't make it okay there are some avoidable costs that we cannot get rid of so it's basically costing us really 3.4 million the true cost that we can avoid so if we don't make it we are getting rid of only because the point is if we can reduce our cost so if we don't make it if we don't make it it will cost us 5 million if we make it it's costing us 3.4 million so we're better off making it rather than not making it because the true cost is 3.4 the other which is the difference is 2.6 million the 2.6 million is the depreciation of the equipment 30 30 dollars times 20 000 units 600 000 and the general factory overhead which is 100 dollar per unit times 20 000 equal to 2 million so those two together is the 2.6 million that is unavoidable cost we can get rid of it therefore the true cost for us is 3.4 not 5 million which is that's what they are that's what they're offering but let's assume we could have avoided 5.2 million dollars in cost if we make it if we can avoid this much then if we can avoid this much from a numerical perspective we will accept the buy because it's cheaper assuming we can avoid that much cost so the decision rule is if you can avoid the cost greater than buying it you will avoid the cost and buy it now bear in mind we have qualitative issues that we have to deal with for example the iphone battery could be the favorite part that the employee produces so if you get rid of it employee morale might go down customer perception if customer knows that apple is not making their own battery they may perceive the product as inferior you could have vendor issues if you buy it from an outsider again you have the supply chain issue the quality issue and you could have other issues as well what should you do that should you do now to practice make or buy go to far hat lectures and work mcqs through false exercises that's going to help you understand this concept better and get you ready whether you are taking an accounting course or studying for your cpa or cma exam good luck study hard and of course stay safe and invest in your education