Make-or-Buy for an Auto Component: Absorbed Overhead, Opportunity Cost and the Indifference Volume
Sunrise Auto Components makes 20,000 units a year of a bracket it could also buy from an approved vendor. The internal cost sheet shows direct material ₹50, direct labour ₹25, variable overhead ₹10, and fixed overhead absorbed at ₹30 per unit (total ₹6,00,000 at 20,000 units). Reported total cost is therefore ₹115 per unit, and the vendor quotes ₹110. The chief financial officer concludes the part should be outsourced. The plant manager objects: if the bracket line is shut, ₹2,50,000 of fixed overhead - supervision and a dedicated maintenance contract - disappears, and the floor space released can be rented out for ₹1,80,000 a year, but only if the entire line is shut down. A second vendor has offered ₹105 per unit, conditional on Sunrise raising annual volume to 25,000 units; at that volume the released space would be needed for incoming stores and could not be rented. Quality records show no difference between the two sources.
1. Prepare the relevant cost comparison at 20,000 units and assess the CFO's reasoning.
Read the worked answer
Relevant costs only.
Make: variable cost 50 + 25 + 10 = ₹85 × 20,000 = ₹17,00,000, plus ₹3,50,000 of fixed overhead that continues either way = ₹20,50,000.
Buy: 110 × 20,000 = ₹22,00,000, plus the same continuing fixed ₹3,50,000, less avoided fixed ₹2,50,000, less rent ₹1,80,000 = ₹21,20,000.
On the difference alone: make ₹17,00,000 versus buy ₹22,00,000 − 2,50,000 − 1,80,000 = ₹17,70,000. Making is cheaper by ₹70,000 a year.
The CFO's error: comparing absorbed full cost of ₹115 with the ₹110 quote. Of the ₹30 absorbed per unit, only ₹12.50 is avoidable; the remaining ₹17.50 is incurred under both options and cannot decide the question.
Judgement: ₹70,000 is about 3% of the buy price - too thin to carry supplier risk, loss of process knowledge, and the chance that ₹110 is an introductory quote. The numbers say make, but only barely, so the qualitative factors are the real tiebreaker.
2. At what volume do the two options become indifferent, and what are the limits of that calculation?
Read the worked answer
Set the relevant costs equal: 85Q = 110Q − (2,50,000 + 1,80,000). The ₹4,30,000 is a fixed benefit of buying, so 25Q = 4,30,000 and Q = 17,200 units.
Above 17,200 units, making wins because its ₹25 per-unit advantage accumulates faster than the fixed savings. Below it, buying wins because the fixed savings dominate the per-unit penalty. At the current 20,000 units Sunrise is only 2,800 units on the make side - a 14% volume drop flips the answer, which matters if the bracket is on a declining platform.
Limits: the formula assumes the full ₹4,30,000 is available at every volume. It is not. The space can be rented only if the line is shut entirely, and supervision costs may not scale down smoothly. The indifference point therefore holds only inside the volume band where a complete shutdown is feasible; at a few thousand units the make option may not exist at all, and at high volumes step costs appear. State these as assumptions rather than burying them.
3. Re-evaluate the decision at 25,000 units with the second vendor's ₹105 quote and no rental income. What should management actually do?
Read the worked answer
Make at 25,000: 85 × 25,000 = ₹21,25,000.
Buy at 25,000: 105 × 25,000 − 2,50,000 = ₹26,25,000 − 2,50,000 = ₹23,75,000.
Making is cheaper by ₹2,50,000, so the decision reverses even though the vendor has cut its price. Two forces explain it: the ₹1,80,000 rental disappears, and the vendor's ₹5 concession is far smaller than the ₹25 gap between internal variable cost and the buy price.
Before committing, test the step costs. The ₹85 unit variable cost is valid at 20,000 units; at 25,000 the line may need a second shift, extra supervision or capital spending, none of which is in the figure. If additional fixed cost exceeds ₹2,50,000, the conclusion flips back.
Judgement: growth, not outsourcing, is the signal here - the volume increase should be met in-house, but the ₹105 quote is volume-contingent and the second vendor now holds process knowledge. Keep the quote as a benchmark, not a standing price.