Make Or Buy

SOLVAY BUSINESS SCHOOL

MBAA.Farber

Finance

MAKE OR BUY ?

A widget manufacturer currently produces 200,000 units a year. It buys widget lids from an outside supplier at a price of $2 a lid. The plant manager believes that it would be cheaper to make these lids rather than buy them. Direct production costs are estimated to be only $1.5 a lid. The necessary machinery would cost $ 150,000. This investment would be depreciated linearly over 5 years. The plant manager estimates that the operation would require additional working capital of $30,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. If the company pays tax at a rate of 40 percent and the opportunity cost of capital is 15 percent, would you support the plant manager's proposal ? State clearly any additional assumptions that you make.

Solution

200,000 widgets a year

Buy / Make
Outside supplier : $2 / widget / Direct production cost : $1.50 / widget
Machinery : $ 150,000
Assume 5-year linear depreciation schedule
Additional working capital : $ 30,000

Tax rate : 34% Cost of capital : 15%

Incremental cash flows

Years 1-5 / Years 6-10
Make / Buy / M-B / Make / Buy / M-B
Revenue / 0 / 0
Op.Cost / 300 / 400 / -100 / 300 / 400 / -100
Dep. / 30 / 0 / +30 / 0 / 0 / 0
Op.Inc / +70 / +100
Taxes / 23.8 / 34
Net Inc / 46.2 / 66
Dep / +30 / 0
FCF / 76.2 / 66

Note : FCF = Op.Inc (1 - Tc) + Tc Dep

NPV

CF / AF / DF / PV
Investment / -150 / 1 / 1 / -150
WCR 0 / -30 / 1 / 1 / -30
FCF 1-5 / +76.2 / 3.352 / 1 / +255
FCF 6-10 / +66 / 3.352 / 0.497 / +110
WCR 10 / +30 / 1 / 0.247 / +7
NPV / +192