Make-or-Buy Decision With a Constrained Resource
Ridgeway Electronics produces 40,000 units of a circuit board annually. Per-unit costs at that volume are: direct materials ₱120, direct labor ₱80, variable overhead ₱40, fixed overhead ₱60, and allocated corporate costs ₱30, totaling ₱330. An outside supplier offers the boards at ₱290 per unit. If Ridgeway buys, 60% of fixed overhead is avoidable and corporate allocations continue. Ridgeway's plant has a single machine that is the bottleneck; producing the boards uses 2 machine hours per unit, and the released capacity could produce a new product generating ₱3,600,000 of contribution margin.
1. Compute the relevant cost of making versus buying and determine whether Ridgeway should accept the supplier's offer, incorporating the opportunity cost of the bottleneck.
Read the worked answer
Relevant make costs exclude unavoidable fixed costs and allocated corporate costs. Per unit: materials ₱120 + labor ₱80 + variable overhead ₱40 = ₱240. Avoidable fixed overhead is 60% × ₱60 = ₱36, so relevant make cost is ₱276 per unit. Unavoidable fixed overhead of ₱24 and corporate allocations of ₱30 are irrelevant.
Buying costs ₱290 per unit. On a pure cost comparison, making is cheaper by ₱14 per unit, or ₱560,000 across 40,000 units.
However, the bottleneck creates an opportunity cost. Using the machine for the boards forgoes ₱3,600,000 of contribution from the new product, or ₱90 per unit (₱3,600,000 ÷ 40,000). Adding this, the relevant cost of making becomes ₱276 + ₱90 = ₱366 per unit, versus ₱290 to buy. Buying is cheaper by ₱76 per unit, or ₱3,040,000 in total. Ridgeway should accept the offer and use the released capacity for the new product, assuming the ₱3,600,000 contribution estimate is reliable and demand exists.
2. The plant manager argues the decision should include all fixed costs because they are real cash outflows. Respond to this argument and identify qualitative factors and risks in the analysis.
Read the worked answer
The manager conflates total costs with relevant costs. Only costs that differ between alternatives matter. The 40% of fixed overhead that continues regardless of the decision, and the allocated corporate costs, do not change and are therefore irrelevant; including them would distort the comparison. The 60% avoidable portion is correctly included because it disappears if production stops.
Qualitative factors matter. Ridgeway must assess the supplier's reliability, quality, and delivery risk; the loss of in-house capability and know-how; labor relations and possible retrenchment costs; and the uncertainty in the ₱3,600,000 contribution estimate for the new product, including whether demand and pricing will hold. The analysis should test sensitivity: if new-product contribution falls below ₱2,480,000 (the point where make cost of ₱276 plus opportunity cost equals ₱290), making becomes preferable. Ridgeway should also confirm the supplier price is firm and consider contract length and escalation clauses before committing.