A common decision is whether a company should buy equipment and produce a product in house or outsource production to another company. If sales volume is high enough, then by producing in house, the savings on unit costs will cover the fixed cost of the equipment. Suppose a company must make such a decision for a four-year time horizon, given the following data. Use simulation to estimate the probability that producing in house is better than outsourcing.
■ If the company outsources production, it will have to purchase the product from the manufacturer for $18 per unit. This unit cost will remain constant for the next four years.
■ The company will sell the product for $40 per unit. This price will remain constant for the next four years.
■ If the company produces the product in house, it must buy a $400,000 machine that is depreciated on a straight-line basis over four years, and its cost of production will be $7 per unit. This unit cost will remain constant for the next four years.
■ The demand in year 1 has a worst case of 10,000 units, a most likely case of 14,000 units, and a best case of 16,000 units.
■ The average annual growth in demand for years 2–4 has a worst case of 10%, a most likely case of 20%, and a best case of 26%. Whatever this annual growth is, it will be the same in each of the years.
■ The tax rate is 40%.
■ Cash flows are discounted at 12% per year.