Garrity Components: Outsourcing GX-4 with an Alternative Use of Space
Garrity Components makes 40,000 units a year of part GX-4 for its own assembly division. At that volume the unit cost is: direct materials $6.20, direct labour $4.10, variable overhead $2.30 and fixed overhead $5.00 (absorbed on direct labour hours), giving $17.60. An external supplier offers all 40,000 units at $16.80 each. If GX-4 is outsourced, 60% of fixed overhead is unavoidable; the other 40% relates to supervision and equipment that could be eliminated. The vacated space could be leased to a neighbour for $78,000 a year, or used to make part HY-9, which is currently purchased for $21.00. Making HY-9 would cost $14.50 a unit in variable cost, with annual demand of 25,000 units and no extra fixed costs. The assembly division reports GX-4 scrap of 3.5% against 1.2% for bought parts, and every scrapped unit delays an assembly carrying $40 of contribution. Garrity has no other use for the space.
1. Calculate the relevant unit cost of making GX-4 and compare it with the supplier's price, before considering the use of the vacated space.
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Relevant cost of making GX-4
| Item | $ per unit | Relevant? |
|---|---|---|
| Direct materials | 6.20 | Yes |
| Direct labour | 4.10 | Yes |
| Variable overhead | 2.30 | Yes |
| Fixed overhead - 40% avoidable (5.00 x 40%) | 2.00 | Yes |
| Fixed overhead - 60% unavoidable (3.00) | - | No: incurred either way |
| Relevant make cost | 14.60 |
The 60% of fixed overhead is a sunk/committed cost and does not differ between alternatives, so it must be excluded. On this comparison, making appears cheaper than buying by $2.20 a unit, or $88,000 a year (40,000 x 2.20).
But this is incomplete: it ignores the opportunity cost of the space and the quality differential. The $88,000 advantage is not the decision.
2. Evaluate the two possible uses of the vacated space and recommend whether Garrity should make or buy GX-4.
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Opportunity cost of the space
- Lease: $78,000 a year.
- Make HY-9: buy cost avoided 25,000 x $21.00 = $525,000; variable cost incurred 25,000 x $14.50 = $362,500; net benefit = $162,500. This is greater than the lease, so the best alternative use is HY-9, and the opportunity cost of making GX-4 is $162,500, or $4.06 per unit (162,500/40,000).
Quality differential
Extra scrap from making = 3.5% - 1.2% = 2.3% x 40,000 = 920 units x $40 contribution = $36,800, or $0.92 per unit. This is a real cost of making and belongs in the analysis.
Full relevant cost of making
14.60 + 4.06 + 0.92 = $19.58 per unit, versus $16.80 to buy. Buying is cheaper by $2.78 a unit, or $111,300 a year (88,000 + 162,500 + 36,800 - 0? reconcile: make total 584,000 + 162,500 + 36,800 = 783,300; buy = 672,000; advantage of buying = 111,300).
Recommendation: outsource GX-4 and use the space to make HY-9. The decision is sensitive to the supplier price; the indifference price is about $19.58, so a fall in the HY-9 benefit or an increase in the scrap penalty would narrow the gap.
3. Identify the qualitative factors that could overturn the quantitative recommendation and the evidence you would seek before signing the contract.
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Qualitative and strategic factors
- Supplier reliability and capacity. A single supplier for a part feeding Garrity's own assembly line creates stoppage risk; penalty clauses and dual sourcing should be tested.
- Quality. The scrap differential of 2.3 percentage points is an estimate; if bought parts also need inspection or rework, the $36,800 saving shrinks. Conversely, if GX-4 scrap causes lost sales rather than just delay, the penalty is understated.
- Workforce. Redundancy, redeployment and morale costs of eliminating supervision and equipment, and the risk of industrial action affecting HY-9.
- HY-9 competence. Garrity has not made HY-9 before; the $14.50 variable cost is an estimate and may include a learning curve. A pilot run would be needed.
- Contract length and price escalation. The $16.80 quote may be introductory; a three-year contract with indexation changes the comparison.
- Loss of design and process knowledge in GX-4, which may matter if the part is later redesigned.
- Space and lease enforceability. Whether the $78,000 lease is a firm offer and whether the space can be recovered.
Evidence to obtain: binding supplier quotation with service levels, HY-9 trial cost data, scrap records by cause, redundancy cost estimates, and a sensitivity analysis on supplier price and HY-9 volume.