Make-or-Buy Decision with Constrained Capacity at a Components Plant
Halden Components makes three parts. Part X sells for 48 and has variable cost 30 (direct materials 12, direct labour 10, variable overhead 8). Part X uses 2 machine hours per unit on the bottleneck machine. Annual demand is 10,000 units. Fixed overhead allocated to X is 90,000 per year and is unavoidable whether X is made or bought. An outside supplier offers to supply all 10,000 units of X at 41 each. The bottleneck machine currently has 18,000 available hours. Part Y also uses the bottleneck: contribution per unit 20 and 1 machine hour per unit, with demand of 4,000 units. Management argues that because the buy price of 41 exceeds the variable cost of 30, buying X would destroy 11 of contribution per unit and should be rejected outright.
1. Compute the relevant cost comparison for buying Part X, treating the bottleneck as the scarce resource, and state whether Halden should buy X.
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Relevant cost of making X per unit: variable cost 30. Fixed overhead of 90,000 is unavoidable and therefore irrelevant.
Relevant cost of buying X per unit: 41, but this ignores the opportunity cost of the freed machine hours.
Bottleneck analysis:
- Hours needed to make 10,000 X = 20,000 hours, but only 18,000 are available. Halden is already capacity-constrained.
- Contribution per machine hour: X = (48 - 30)/2 = 9 per hour; Y = 20/1 = 20 per hour. Y is far more profitable per scarce hour.
Opportunity cost of making X: each unit of X consumes 2 hours that could earn 20 per hour on Y, so the opportunity cost is 40 per unit of X. Relevant cost of making X = 30 + 40 = 70, versus buy price 41. Making X costs 29 more per unit than buying, or 290,000 per year across 10,000 units.
Recommendation: Buy X and redeploy the freed hours to Y. Note the capacity arithmetic: making 10,000 X needs 20,000 hours but only 18,000 exist, so the current plan is infeasible - Halden would have to forgo Y production or buy some X anyway. The optimal plan is to buy all X, use hours for Y up to its 4,000-unit demand (4,000 hours), and release the remaining hours. Even ignoring Y, the buy price of 41 exceeds the avoidable variable cost of 30 by 11, so the make option only wins if the freed hours have no alternative use - which is not the case here.
2. Identify two qualitative factors and one quantitative risk that could overturn the numerical recommendation, and explain how each would be incorporated.
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Qualitative factors:
- Supplier reliability and quality. If the external supplier has a history of late delivery or quality defects, the 41 price understates the true cost of buying (rework, expediting, lost customer goodwill). This would be incorporated by adding an expected cost of poor quality and delay to the buy price; if that pushes the effective buy cost above 70, making X becomes preferable.
- Loss of know-how and workforce. Outsourcing X may erode process expertise and require redundancy payments or retention of skilled staff. One-off restructuring costs should be treated as relevant cash flows in the year they occur, not spread arbitrarily.
Quantitative risk: The opportunity cost of 40 per unit assumes Y demand of 4,000 units holds and that Y's contribution of 20 per hour is stable. If Y demand falls, the freed hours have no alternative use and the opportunity cost collapses toward zero, at which point making X (variable cost 30) beats buying (41). A sensitivity check: the recommendation flips when the contribution per hour available on alternative work falls below (41 - 30)/2 = 5.50 per hour. Management should monitor Y's order book; if alternative contribution per hour drops below 5.50, revert to making X.
Also note the fixed overhead: if the 90,000 is in fact avoidable on exit (for example, a dedicated supervisor), it becomes relevant and reduces the buy advantage by 9 per unit - still not enough to reverse the decision, but it must be tested rather than assumed.