Make-or-Buy for Component RX
Anand Auto Components uses 24,000 units of component RX each year in its assembly line. At this volume the in-house cost per unit is: direct materials ₹42, direct labour ₹28, variable overhead ₹15 and fixed overhead ₹30, totaling ₹115. The fixed overhead includes ₹4,80,000 of depreciation and supervision that will continue whether RX is made or bought, and ₹2,40,000 of power and maintenance that can be avoided if production stops. An outside supplier offers RX at ₹98 per unit. If Anand outsources, the released space can be rented for ₹1,80,000 a year, but Anand will incur ₹60,000 a year in extra incoming inspection and logistics. The quality manager warns that the supplier’s process has a 2% reject rate and Anand would bear the cost of rejected units; no rework is possible. The production manager argues that the supplier quote should be compared with the ₹115 full cost, while the finance manager wants a relevant-cost analysis. Annual demand is expected to remain stable.
1. Compute the relevant annual cost of making and of buying component RX, ignoring the reject rate for the moment, and advise whether to make or buy. Explain why the ₹115 full cost is misleading.
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Relevant make cost: variable cost = (₹42 + ₹28 + ₹15) × 24,000 = ₹85 × 24,000 = ₹20,40,000. Avoidable fixed cost = ₹2,40,000. Total relevant make cost = ₹22,80,000.
Relevant buy cost: purchase cost = ₹98 × 24,000 = ₹23,52,000; add extra inspection and logistics ₹60,000; deduct rental income from released space ₹1,80,000. Total relevant buy cost = ₹23,52,000 + ₹60,000 − ₹1,80,000 = ₹22,32,000.
Buying is cheaper by ₹22,80,000 − ₹22,32,000 = ₹48,000 a year. The ₹115 full cost includes ₹4,80,000 of depreciation and supervision that continue even if RX is bought. That is ₹20 per unit of unavoidable fixed cost, so comparing ₹98 with ₹115 overstates the benefit of outsourcing. The decision should be based on relevant costs, subject to qualitative factors.
2. Now incorporate the supplier’s 2% reject rate. Recompute the relevant buy cost, advise whether to outsource, and calculate the supplier price at which Anand would be indifferent.
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To obtain 24,000 good units with a 2% reject rate, Anand must buy 24,000 ÷ 0.98 = 24,489.8, rounded up to 24,490 units. Purchase cost = 24,490 × ₹98 = ₹24,00,020. Relevant buy cost = ₹24,00,020 + ₹60,000 − ₹1,80,000 = ₹22,80,020.
Relevant make cost remains ₹22,80,000. Buying now costs ₹20 more than making, so the decision is effectively indifferent, but the supplier quality risk makes buying unattractive unless the price or reject rate improves.
Indifference price: let P be the price per gross unit. P × 24,490 + ₹60,000 − ₹1,80,000 = ₹22,80,000. Therefore P × 24,490 = ₹24,00,000, so P = ₹24,00,000 ÷ 24,490 = approximately ₹98.00. Any price below about ₹98 per gross unit makes buying cheaper; a price above ₹98 favours making.
3. Identify the qualitative factors Anand should consider before outsourcing, and explain how they could change the quantitative conclusion.
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Qualitative factors include supplier reliability and delivery lead time, the 2% reject rate and whether it can be reduced by a quality agreement, the supplier’s financial stability, and the risk of dependence on a single source. Anand should also consider workforce implications, loss of in-house technical knowledge, and whether the released space can be rented reliably for ₹1,80,000 a year. If the rental income is uncertain, the relevant buy cost rises and making becomes more attractive.
The quantitative result is close: buying costs ₹20 more after rejects, so a small adverse quality or delivery event could erase the apparent indifference. A supplier guarantee, penalty for rejects or a price reduction below ₹98 would favour buying. Conversely, if the supplier’s rejects disrupt assembly or the rental market weakens, Anand should retain production even if the simple relevant-cost calculation looks marginally favourable to buying.