Make-or-Buy Decision with Constrained Capacity and Qualitative Factors
Halbrook Components makes a subassembly (Part X) used in its main product. Annual demand is 24,000 units. In-house variable cost is 18 per unit (direct materials 8, direct labor 5, variable overhead 5), and fixed overhead allocated is 6 per unit based on 24,000 units, of which 90,000 is avoidable if Part X is discontinued. An outside supplier offers Part X at 21 per unit for all 24,000 units. Halbrook's plant is currently operating at full capacity on its main product, which earns a contribution margin of 7 per unit and uses the same machine hours as one Part X (one machine hour per unit). If Part X is outsourced, the freed capacity can produce 24,000 additional main-product units-but market demand for the main product is only 15,000 additional units. The supplier requires a minimum order of 30,000 units and a two-year commitment. Quality defects in outsourced parts have historically run 2%, versus 0.5% in-house.
1. Compute the relevant cost of making versus buying Part X, incorporating the opportunity cost of constrained capacity, and recommend a decision.
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Relevant cost to make (per unit and total). Only avoidable costs are relevant. Variable cost = 18/unit × 24,000 = 432,000. Avoidable fixed = 90,000. Total avoidable make cost = 522,000, or 21.75/unit. The remaining allocated fixed overhead (6 × 24,000 − 90,000 = 54,000) is unavoidable and irrelevant.
Opportunity cost of capacity. Capacity is the binding constraint. If Part X is outsourced, freed machine hours = 24,000 hours, but only 15,000 additional main-product units can be sold (demand-limited). Contribution from those = 15,000 × 7 = 105,000. The remaining 9,000 hours have no alternative use, so their opportunity cost is zero. Total relevant cost to make including opportunity cost = 522,000 + 105,000 = 627,000.
Relevant cost to buy. Purchase price = 21 × 24,000 = 504,000, but the supplier requires a minimum of 30,000 units. If Halbrook must buy 30,000 and only needs 24,000, the extra 6,000 units cost 21 each = 126,000 with no use-unless resalable. Relevant buy cost = 504,000 + 126,000 = 630,000 (assuming excess unusable). Add expected quality cost: at 2% defect rate on 24,000 = 480 defective units; if rework/scrap costs 18/unit variable, that is 8,640, versus in-house 0.5% = 120 units × 18 = 2,160. Incremental quality cost ≈ 6,480.
Comparison. Make: 627,000. Buy: 630,000 + 6,480 = 636,480. Making is cheaper by about 9,480. Recommendation: make in-house, but flag the two-year commitment and minimum-order risk.
2. Identify the qualitative and strategic factors that could overturn the quantitative recommendation, and explain how the two-year commitment changes the analysis.
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Qualitative factors. (1) Supplier reliability and quality: a 2% defect rate raises warranty, rework, and reputation risk; if defects reach customers, the cost is not captured in the 18/unit variable estimate. (2) Loss of control over proprietary design: outsourcing Part X may expose trade secrets or reduce flexibility to modify the main product. (3) Supplier bargaining power: a two-year commitment locks Halbrook into a price that may become uncompetitive if materials costs fall. (4) Workforce and know-how: laying off skilled workers may be hard to reverse. (5) Capacity strategy: the freed 9,000 hours have no current use, but future demand growth could make them valuable; the analysis assumes demand stays at 15,000 additional units.
Effect of the two-year commitment. The quantitative comparison is annual; over two years, the make advantage of ~9,480/year compounds to ~18,960, but the commitment also creates a contractual obligation that is a fixed cost regardless of volume. If demand for the main product falls, Halbrook still must buy 30,000 Part X units, converting a variable cost into a committed fixed cost and increasing operating leverage. Conversely, if main-product demand rises above 15,000, the opportunity cost of making Part X rises, potentially flipping the decision. Sensitivity: the make option remains cheaper as long as incremental main-product contribution from freed capacity is less than the buy premium plus quality costs. The recommendation should be conditional-make now, but revisit if supplier quality improves or main-product demand exceeds roughly 16,400 additional units, at which point the opportunity cost overtakes the buy premium.