Example 5: Make Vs. Buy

The Chemplast Company manufactures and sells a range of high quality industrial containers. It has established a reputation in the industry for quality and timely delivery of its containers. The company is considering closing the container department and outsourcing the production of its containers to another company, Containers Inc, who has offered to supply the required number of containers at $1,100,000 each year for the next 5 years. The annual expenses of the container department are as follows:

Material...		$ 700,000
Labor......		400,000
Overheads.
Manager Smiths salary....	100,000
Rent	80,000
Depreciation of machinery..	100,000
Other expenses...	60,000
Allocation of general administrative expenses	70,000
		410,000
Total annual cost of department..		$ 1,510,000

Materials for the next year are already in inventory and will have to be discarded if the outsourcing contract with Containers Inc is agreed upon. Even if this department is closed, another managerial position was becoming available outside of the firm to which Smith would move without loss of pay or prospects (Smith would not ask for compensation in this case leaving Chemplast). The company was paying $80,000 per year in rent for a warehouse for other corporate purposes. If the container department is closed, Chemplast would have all the space it needs and not need to rent the said warehouse.

Currently, the company spends $280,000 annually on general administrative expenses that it allocates equally to each of its 4 departments. The company does not expect any savings in its administrative expenses from closing down the container department.

The machine used in the production process was purchased 4 years ago for $800,000. Depreciation for book and tax purposes is straight line over 8 years. The book value of the machine is $400,000, and is expected to last for 5 more years. If the department is closed, the machine can be sold today for $200,000.

Assume that the company has a 5 year horizon for this project, that the companys cost of capital is 10%, and that its tax rate is 40%. Should the company outsource its production? (Assume all cash flows for a period occur at the end of the period)

Making:

	Year 1	Year 2	Year 3	Year 4	Year 5

Outsourcing:

	Year 0	Year 1-5