Exercise / Step 6 / Make or Buy
A concrete exercise to show you how to make the decision between manufacturing or subcontracting
You are, now, in the situation of a company which considers in-sourcing an activity that is currently run by a supplier.
Download and open the frame spreadsheet document.
Currently, you purchase 10,000 units per year at a unit price of $ 80.
What if we manufacture by ourselves?
Then, you need to buy a machine and evaluate your cost structure (labor, raw materials and overheads, as in step 5). Of course, you need a time horizon, a tax rate and a WACC, all provided in the spreadsheet.
The calculation looks like the ‘productivity case’ but it’s not about replacing one machine by another, it’s about replacing a sub-contractor by your own team.
First, calculate NPV and IRR, both demonstrate that this in-sourcing case is profitable.
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Question 1 of 7
1. Question
What is the annual cash flow?
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Question 2 of 7
2. Question
What is the Internal Rate of Return of the project?
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Question 3 of 7
3. Question
The second part of the exercise is devoted to Working Capital Requirement.
Any in- or out-sourcing activity, obviously, impacts the Capital Employed through non-current assets (buying or not a machine), but the WCR as well. No change in the accounts receivable, because you change production, not sales. But, you modify the inventories of raw materials and finished goods, together with accounts payable.
Calculate the impact on raw material inventory (365 days per year).
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Question 4 of 7
4. Question
Calculate the impact on finished goods inventory (365 days per year). You replace 10 days of purchases by 10 days of manufactured products.
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Question 5 of 7
5. Question
Calculate the impact on accounts payable. You replace 60 days of finished goods purchases by 60 days of raw materials purchases.
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Question 6 of 7
6. Question
Calculate the total impact on the WCR. Remember that an increase (resp. decrease) in the inventory is an increase (resp. decrease) in the WCR, but an increase (resp. decrease) in the accounts payable is a decrease (resp. increase) in the WCR. This is the direct consequence of the formula: WCR = inventory + A/R – A/P.
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Question 7 of 7
7. Question
Last, you enter the cash impact of the WCR increase in cell D37 and don’t forget to recover the increase in cell L37.
What is the new IRR?
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