Absorption Costing and a Make-or-Buy Decision Under Constraint
Halbrook Components makes three products, A, B and C, on a single machine that is available for 10,000 hours per year. Per-unit data: A sells for $60, uses 2 machine hours and $28 variable cost; B sells for $45, uses 1 hour and $18 variable cost; C sells for $90, uses 4 hours and $50 variable cost. Fixed overhead of $180,000 is absorbed at $18 per machine hour, and the current plan fully utilises the machine producing 2,000 A, 2,000 B and 1,000 C. A customer offers to supply component B externally for $30 per unit, freeing machine time. The sales director wants to accept immediately because $30 is below the $36 absorption cost of B.
1. Evaluate the outsourcing offer and recommend a production plan if B is bought in.
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Absorption cost is a red herring because the $180,000 fixed overhead is unavoidable and irrelevant to the decision. Compare relevant costs: making B costs $18 variable; buying costs $30, so buying appears $12 worse per unit. But the freed time has an opportunity cost. Contribution per machine hour is A: ($60-$28)/2 = $16; B: ($45-$18)/1 = $27; C: ($90-$50)/4 = $10. B is the most profitable use of the constraint, so buying it in destroys value unless the freed hours are redeployed to A or C. Each B bought in frees 1 hour; the best alternative use is A at $16 per hour, so the net cost of outsourcing is $12 + $16 = $28 per unit worse. Recommendation: keep making B and prioritise it, then A, then C.
2. Demand for C rises so that all C demand (3,000 units) must be met. Recalculate the optimal plan and state the limiting factor.
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Meeting 3,000 C consumes 12,000 hours, which exceeds the 10,000 available, so C demand cannot be fully satisfied and the machine remains the limiting factor. Rank by contribution per hour again: B $27, A $16, C $10. Satisfy B first (2,000 hours), then A (4,000 hours), leaving 4,000 hours for 1,000 units of C. The plan is 2,000 B, 2,000 A and 1,000 C, with unmet C demand of 2,000 units. The judgement is that ranking is by contribution per unit of the scarce resource, not by selling price or gross margin, and that fixed overhead absorption rates should not drive the ranking.