Business administration: TestAS practice testlets

Many firms must decide whether to produce a component themselves or to buy it from a supplier. This make-or-buy decision depends on costs, but also on quality, reliability, know-how and flexibility. The cost comparison uses the distinction between fixed and variable costs. Producing in-house usually requires fixed costs for machines, space and specialised staff, but the variable cost per unit may be low. Buying requires no fixed costs, but each unit costs the supplier's price, which includes the supplier's own costs and profit.

For small quantities, buying is typically cheaper, because the fixed costs of in-house production would be spread over only a few units. For large quantities, making becomes cheaper, because the lower variable cost saves more than the fixed costs. The quantity at which both options cost the same is the critical quantity, a kind of break-even point between two alternatives. It is found by setting the total costs of both options equal.

fixed costs (make) + variable cost (make) × Q = purchase price × Q critical quantity Q* = fixed costs ÷ (purchase price − variable cost of making)

The calculation is only part of the decision. Only costs that actually change with the decision should be considered: a machine that the firm already owns and cannot sell does not cause additional fixed costs, even though its depreciation appears in the accounts. Buying from outside may free capacity that can be used for more profitable products, which is an opportunity cost of making. On the other hand, relying on a single supplier creates dependence: if the supplier raises prices, delivers late or goes out of business, production may stop. Firms therefore also consider whether a component is part of their core competence, whether its quality is critical, and whether keeping the know-how in-house is strategically important. Contracts with several suppliers can reduce the risk of dependence.

In recent years, many firms have reconsidered outsourcing decisions after disruptions of global supply chains showed the risks of long transport routes and concentrated suppliers.

A manufacturer of bicycles needs a special gear component. It can produce it in-house or buy it from a supplier. Expected demand is 12,000 units per year.

Every company prepares two basic financial statements. The balance sheet is a snapshot at a particular date. On one side it lists the assets, everything the firm owns or is owed, such as buildings, machines, inventory, amounts customers still owe (receivables) and cash. On the other side it shows how these assets are financed: by the owners' capital (equity) and by debts to others (liabilities), such as bank loans and amounts owed to suppliers (payables). Both sides are always equal, because every asset is financed somehow.

assets = equity + liabilities

The income statement, also called the profit and loss account, covers a period, usually a year. It starts with revenue, the value of goods and services sold, and subtracts expenses. Deducting the cost of the goods sold gives the gross profit. Deducting operating expenses such as salaries, rent and depreciation gives the operating profit, often called EBIT (earnings before interest and taxes). Subtracting interest gives the profit before tax, and subtracting income tax gives the net profit. The net profit increases equity on the balance sheet unless it is paid out to the owners.

Profit and cash are not the same. Revenue is recorded when goods are delivered, even if the customer pays later, so a firm can report a profit while running short of cash. Conversely, buying a machine uses cash immediately but appears in the income statement only gradually, as depreciation over its useful life.

Many transactions change the balance sheet without affecting profit. Buying a machine for cash exchanges one asset for another; taking out a bank loan increases cash and liabilities by the same amount. The totals on each side change only when both sides are affected.

In Germany, the rules for these statements are set by the Commercial Code (HGB), while listed groups use international standards (IFRS). Both rest on the principle of double-entry bookkeeping, in which every transaction is recorded twice, once on each side of an account, which keeps the balance sheet in balance. Larger companies must have their annual statements checked by an independent auditor.