Calder Furniture: Outsourcing with Scarce Capacity and Quality Risk
Calder Furniture manufactures 24,000 units of component X each year. The variable cost is £18 per unit, and £120,000 of fixed overhead is allocated to the component. An external supplier has offered to supply all 24,000 units at £21 each. If Calder outsources, 30% of the allocated fixed overhead would be avoided, and the freed capacity could be used to produce 6,000 units of product Y, which has a contribution of £9 per unit. The supplier’s quality record shows a defect rate of 2%, compared with Calder’s current 0.5%; each defect costs £12 to rework. The supplier requires a three-year contract with a price review after 12 months. Calder’s workforce is concerned about job losses, and the production manager argues that outsourcing would erode process knowledge. Demand for product Y is forecast but not contracted.
1. Prepare a relevant cost analysis and recommend whether Calder should outsource component X.
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Relevant cost of making in-house
Variable cost: 24,000 × £18 = £432,000. Avoidable fixed cost: 30% × £120,000 = £36,000. Rework: 24,000 × 0.5% × £12 = £1,440. Total = £469,440.
Relevant cost of outsourcing
Purchase price: 24,000 × £21 = £504,000. Less contribution from product Y: 6,000 × £9 = £54,000. Rework: 24,000 × 2% × £12 = £5,760. Total = £455,760.
Outsourcing saves £469,440 - £455,760 = £13,680 a year, or 2.9% of the in-house relevant cost. The indifference supplier price is (£469,440 + £54,000 - £5,760) / 24,000 = £21.57 per unit.
Recommendation
Outsource on financial grounds, but only marginally. The decision is sensitive to the demand for product Y: if fewer than about 4,480 units of Y are sold, the contribution benefit falls and the case weakens. Calder should secure a pilot or dual-sourcing arrangement before committing to the three-year contract.
2. Discuss the qualitative and risk factors, and recommend safeguards before Calder commits to the supplier.
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Qualitative factors
- Supplier dependency: a three-year contract with one supplier creates hold-up risk at the 12-month price review. Calder should negotiate price benchmarks, volume flexibility and exit rights.
- Quality: the supplier’s 2% defect rate is four times Calder’s current rate. The £12 rework cost may understate the cost of disruption, late delivery and reputational damage.
- Workforce: job losses and lost process knowledge can damage morale and make future insourcing difficult. Consultation and retraining should be planned.
- Demand uncertainty: the £54,000 contribution from product Y is not contracted. If Y demand fails, the outsourcing case disappears.
- Strategic fit: component X may be core to quality or intellectual property; outsourcing could erode competitive advantage.
Safeguards
Before signing, Calder should run a trial with service-level penalties, retain a small in-house capability, require supplier quality certification and access to process data, and review the contract after 12 months. The board should approve outsourcing only if the Y demand forecast is robust and the supplier accepts quality and price-review clauses.