Make or Buy

Make or Buy

The relationship between costs and activity is known as cost behaviour, while the cost structure of a company refers to the compilation or the nature of its production costs -whether fixed, variable or mixed (semi variable). Variable costs can be divided into true variable cost and step variable cost, whereas fixed costs can be divided into committed and discretionary fixed cost. (In this regard see Horngren et al 2003; Garrison and Noreen 2000; Blocher, Chen and Lin 2002; Hansen and Mowen 2000; Hilton 1997.) Companies with a high fixed cost component and low variable cost component are more sensitive to changes in activity than companies with a low fixed cost component and a high variable cost component (Correia et al 2003). Thus, it is the fixed cost component that is responsible for the operating risk of a company. Benedetti (2000) suggests that, when demand declines, a company should try to shift fixed cost to variable cost by means of flexible contracts, outsourcing, cost-led pricing and pay-for-performance plans.

Capital intensive companies are at greater risk than labour intensive companies because of their relatively high fixed cost and low variable cost components (Garrison and Noreen 2000:300; La Roy 2000). Thus, compared to labour intensive companies, capital intensive companies have a high contribution margin, high operating leverage and high volatile profit. The degree of technological development can be used to determine whether a company is capital intensive or labour intensive. In technologically developed companies, production processes are mainly automated and machines perform the bulk of the production processes. Some of these machines are controlled by computers, enabling companies to produce better quality products, deliver better services, keep a smaller amount of inventory and improve the adaptability of the production process. The costs involved in implementing such automated production processes are high, and therefore result in high fixed costs (Fry, Stoner and Hattwick 1998:465; Hilton 1997:253-254, 274).

There are a variety of reasons why manufacturing companies classify costs as fixed or variable components. These reasons include price fixing, decreasing costs, profit planning, cost-benefit analysis, cost-volume-profit analysis and budgeting (Horngren, Foster, Datar and Uliana 1999:37). Manufacturing companies may also use different methods to classify cost behaviour, namely managerial judgement, engineering approach, quantitative analysis (such as the high-low method), visual fit and regression analysis (Horngren et al 2003; Drury 2000).

Direct labour will probably be a fixed cost for the company as a whole ...