Teloxy Engineering And The Make-Or-Buy Decision For Componen

Teloxy Engineering and the Make-or-Buy Decision for Component Sourcing

Teloxy Engineering has been awarded a one-time contract to design and produce 10,000 units of a new product. During the initial proposal, management estimated that a critical component could be purchased at a cost of $60 per unit, including quantity discounts, with an overall budget of $650,000 allocated for procurement and handling costs. However, subsequent design modifications indicated the necessity of a higher-grade component that sells for $72 per unit, which significantly exceeds the original budget. This shift prompts a critical decision: should Teloxy manufacture the component internally or continue purchasing it from the market?

The manufacturing team has indicated that they can produce up to 10,000 units, aligning with the order quantity, but this option entails a setup cost of $100,000 and a raw material cost of $40 per component. Additionally, as the company is new to manufacturing this component, there is an expected defect rate, leading to defective products that must be repaired or replaced. The repair cost is estimated at $120 per defective part, with the assumption that all defective units are identified and repaired at the end of production.

To evaluate the most economical option, an expected value analysis must be conducted, comparing the costs associated with buying versus manufacturing. The key variables involve the costs per component, defect rates, and defect repair costs. First, the cost to manufacture includes the setup cost, raw material costs, and the expected cost due to defective units. Second, the cost to buy involves the purchase price plus any handling expenses, which are assumed to be incorporated within the purchase price or minimal.

For manufacturing, the total expected cost per unit (ECU) can be calculated by summing the fixed costs and the variable costs, considering defect rates. The expected defect rate can be derived from historical or industry data, but in this scenario, an estimated defect rate of 10% is assumed for illustrative purposes, which means that 1,000 units are defective out of 10,000 produced. The total manufacturing cost thus includes the setup cost of $100,000, raw materials at $40 per unit, and repair costs for defective units: 1,000 defective units at $120 each, totaling $120,000 for repairs.

Consequently, the total manufacturing cost (TMC) is calculated as: TMC = setup costs + (production cost per unit x total units) + repair costs for defective units. This yields TMC = $100,000 + ($40 x 10,000) + $120,000 = $100,000 + $400,000 + $120,000 = $620,000. The expected manufacturing cost per unit, then, is $620,000 divided by 10,000, which is approximately $62 per unit.

On the other hand, the cost to buy the component at the new price of $72 per unit totals $720,000 for 10,000 units. This exceeds the allocated budget of $650,000, evidencing a cost overrun. However, the expected value incorporates potential cost savings or overruns resulting from defect management. Since buying involves no setup costs and minimal handling costs, the expected total cost remains $720,000, but the actual per-unit cost after accounting for defects and handling could be analyzed for further accuracy.

Based on the expected costs, manufacturing at approximately $62 per unit is more economical than purchasing at $72, given the assumptions. Nonetheless, this analysis is sensitive to the defect rate and repair costs; higher defect rates or repair costs would tilt the balance further in favor of purchasing. Conversely, if defect rates were lower or manufacturing efficiencies improved, producing in-house could present a cost advantage. Ultimately, under current assumptions, manufacturing internally is the more cost-effective option, aligning with the principles of expected value analysis and cost minimization.

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