Teloxy Engineering has received a one-time contract to design and build 10,000 units of a new product. During the proposal process, management felt that the new product could be designed and manufactured at a low cost. One of the ingredients necessary to build the product was a small component that could be purchased for $60 in the marketplace, including quantity discounts. Accordingly, management budgeted $650,000 for the purchasing and handling of 10,000 components plus scrap.
During the design stage, your engineering team informs you that the final design will require a somewhat higher-grade component that sells for $72 with quantity discounts. The new price is substantially higher than you had budgeted for. This will create a cost overrun.
You meet with your manufacturing team to see if they can manufacture the component at a cheaper price than buying it from the outside. Your manufacturing team informs you that they can produce a maximum of 10,000 units, just enough to fulfill your contract. The setup cost will be $100,000 and the raw material cost is $40 per component. Since Teloxy has never manufactured this product before, manufacturing expects the following defects:
All defective parts must be removed and repaired at a cost of $120 per part.
1. Using expected value, is it economically better to make or buy the component?
2. Strategically thinking, why might management opt for other than the most economical choice?
TELOXY ENGINEERING (B)
Your manufacturing team informs you that they have found a way to increase the size of the manufacturing run from 10,000 to 18,000 units in increments of 2000 units. However, the setup cost will be $150,000 rather than $100,000 for all production runs greater than 10,000 units and defects will cost the same $120 for removal and repair.
1. Calculate the economic feasibility of make or buy.
2. Should the probability of defects change if we produce 18,000 units as opposed to 10,000 units?
3. Would your answer to question 1 change if Teloxy management believes that followon contracts will be forthcoming? What would happen if the probability of defects changes to 15 percent, 25 percent, 40 percent, 15 percent, and 5 percent due to learning-curve efficiencies?