Nandini Appliances - Make or Buy with a Genuine Opportunity Cost for the Space
Nandini Appliances makes 24,000 units of component X1 a year for its own assembly line. The cost card per unit shows direct material ₹120, direct labour ₹80, variable overhead ₹40 and absorbed fixed overhead ₹60 - a total of ₹300. Fixed overhead in the component shop is ₹14,40,000 a year, absorbed at ₹60 per unit. A trader has offered to supply all 24,000 units at ₹270 each, delivered. Closing the component shop would eliminate 45% of its fixed overhead; the remaining 55% - supervisors' salaries and a share of factory rent - would continue. The floor space released is currently idle. Two uses have been proposed: renting it to a neighbouring business for ₹1,50,000 a year, or using it for a new product expected to earn a contribution of ₹2,10,000 a year with no additional capital spending. The plant accountant favours the trader because ₹270 is below the ₹300 full cost; the works manager rejects it because ₹270 is above the ₹240 variable cost. The managing director wants the question settled with numbers.
1. Compute the relevant cost per unit of making X1 and recommend, ignoring the alternative uses of the space.
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Strip out what does not change with the decision:
- Direct material ₹120 + direct labour ₹80 + variable overhead ₹40 = ₹240 relevant variable cost.
- Of the ₹60 absorbed fixed overhead, only the 45% that disappears is relevant: 45% × ₹60 = ₹27 per unit (₹6,48,000 a year). The remaining ₹33 per unit (55% × ₹60 = ₹7,92,000) continues whether or not the shop closes and is irrelevant.
Relevant cost of making = ₹240 + ₹27 = ₹267 per unit. Relevant cost of buying = ₹270.
For 24,000 units: make ₹64,08,000 against buy ₹64,80,000 - making is cheaper by ₹72,000 a year, so keep the shop.
Both managers reached the right answer, one for the wrong reason:
- The accountant compared ₹270 with the ₹300 full cost, which includes ₹33 of unavoidable overhead. That overstates the cost of making and understates the advantage of making.
- The works manager compared ₹270 with ₹240 and ignored the ₹6,48,000 of fixed cost that would genuinely disappear. That understates the cost of making.
The defensible comparison is relevant cost against relevant cost: ₹267 vs ₹270. The margin is only ₹3 a unit, so the conclusion is fragile and everything now depends on the numbers in the next two questions.
2. Redo the analysis including each of the two possible uses of the released space, and advise.
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If the shop closes, the space has a value; that value is an opportunity cost of continuing to make.
(a) Rental of ₹1,50,000 a year
- Make: ₹64,08,000.
- Buy: ₹64,80,000 less rent received ₹1,50,000 = net ₹63,30,000.
- Buying wins by ₹78,000.
Same answer by the other route: making forgoes the rent, so the cost of making is 64,08,000 + 1,50,000 = ₹65,58,000 against ₹64,80,000.
(b) New product contribution ₹2,10,000 a year
- Make: 64,08,000 + 2,10,000 forgone = ₹66,18,000.
- Buy: ₹64,80,000.
- Buying wins by ₹1,38,000.
And of the two ways to use the space, the new product (₹2,10,000) beats the rental (₹1,50,000) by ₹60,000, so the best plan overall is: outsource X1 and launch the new product, giving a gain of ₹1,38,000 a year over continuing to make.
Note the pattern: the make-versus-buy comparison alone gives a ₹72,000 advantage to making, which is reversed by any alternative use of the space worth more than ₹72,000 a year. The recommendation is driven by the opportunity cost, not by the supplier's price.
3. What further factors could reverse the recommendation, and what is the maximum annual rental at which making still wins?
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Break-even: making wins only while the alternative value of the space is below ₹72,000 a year (₹3 × 24,000 units). Every cost figure is now fixed; only the assumptions can move.
Factors that could change the answer:
- Volume risk. The advantage is ₹3 per unit. At 20,000 units it shrinks to ₹60,000 and the rental option wins sooner. Outsourcing also converts a fixed cost into a variable one, which is valuable if demand is volatile.
- The "unavoidable" 55%. That is a one-year judgement. Over three to five years, supervisors can be redeployed, the rent share renegotiated and the shop sub-let or sold - the avoidable fixed cost is larger in the long run, which strengthens the case for buying.
- One-off exit costs. Redundancy, notice pay and industrial-relations costs are real cash outflows of closing and belong in the comparison.
- Supplier risk. Sole-sourcing 24,000 units: what happens at renewal, and what does a missed delivery cost when the assembly line stops?
- Quality and know-how. X1 is designed in-house; losing the process capability may matter more than ₹72,000 a year.
- The quote itself. Is ₹270 firm, indexed for material prices, and does it include freight and incoming inspection?
Advice: the numbers are close enough that this is a strategic decision, not an arithmetic one. If the space can earn ₹2,10,000, outsource - but contract for a trial period and retain the option to bring X1 back in-house rather than demolishing the shop.