• Outlay costs include costs for items such as materials and labor. • Opportunity cost is the maximum available benefit forgone (or passed up) by using such a resource for a particular purpose instead of the best alternative use.
Opportunity Cost - Nantucket Nectars 1. Peach Juice Contribution margin is $60,000. 2. Sell machine for $50,000. 3. Produce Papaya Mango juice with projected sales of $500,000. Suppose Nantucket Nectars will have total sales over the life cycle of Papaya Mango 100% Juice of $500,000. The production and marketing costs (outlay costs), excluding the cost of the machine, are $400,000. What is the net financial benefit from producing the Papaya Mango?
Opportunity Cost - Nantucket Nectars Revenues $500,000 Costs: Outlay costs 400,000 Financial benefit before opportunity costs $100,000 Opportunity cost of machine 60,000 Net financial benefit $ 40,000 Nantucket Nectars will gain $40,000 more financial benefit using the machine to make Papaya Mango than it would make using it for the next most profitable alternative.
Why Opportunity costs? • When there is only one resource and one alternative opportunity to use that resources, the incremental analysis is more straight forward • Using opportunity costs allows us to simplify the analysis • Just assess the alternatives for each machine, pick the best one to use in determining each machine’s opportunity costs and add the five opportunity costs to the outlay costs of the project
Sunk Costs Sunk costs are dollars already spent and permanently lost. Sunk costs cannot be refunded or recovered. Example: House Construction, Production Machinery
Learning Objective 2 Make-or-Buy Decisions
Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier.
Make-or-Buy Decisions Outsourcing is the strategic use of outside resources to perform activities traditionally handled by internal staff and resources
Make-or-Buy Decisions Whether a company should make its own parts that it will use in its final products or buy the parts from vendors
Make-or-Buy Decisions Reasons for Buying Lack of technical experience Supplier's expertise on the technical areas and the domain Cost considerations Need of small volume Insufficient capacity to produce in-house Brand preferences Strategic partnerships Reasons for Making Cost concerns Desire to expand the manufacturing focus Need of direct control over the product Intellectual property concerns Quality control concerns Supplier unreliability Lack of competent suppliers Volume too small to get a supplier attracted Reduction of logistic costs (shipping etc.) To maintain a backup source Political and environment reasons Organizational pride
Make-or-Buy Decisions • An Atlanta bakery has offered to supply the in-flight desserts for .21¢ each. • Here are Worldwide’s current cost for desserts: Variable costs: Direct material 0.06 $ Direct labor 0.04 Variable overhead 0.04 Fixed costs: Supervisory salaries 0.04 Depreciation of equipment 0.07 Total cost per dessert 0.25 $