Make It or Buy It When the Full Cost Lies
Kaveri Engineering makes 24,000 units of component X a year. The cost sheet shows direct material ₹42, direct labour ₹18, variable overhead ₹15, and fixed overhead absorbed at ₹25 per unit on normal capacity, so the full cost is ₹100 per unit. Total fixed overhead absorbed is ₹6,00,000, of which ₹2,40,000 is supervision and machine upkeep attributable solely to X and would disappear if X were bought.
An outside supplier offers X at ₹102 per unit delivered, with a guarantee of 100% acceptable quality and delivery to the shop floor. In-house, about 2% of X units are rejected at final inspection and scrapped with no recovery.
If X is bought, the released floor space and manpower can produce 6,000 units of product Y, giving a contribution of ₹4,00,000 a year; market demand for Y at that volume has been confirmed by the sales manager. The purchase manager says the amounts are a wash because ₹102 is so close to ₹100.
1. Compute the relevant annual cost of making and of buying, and recommend a decision with the saving quantified.
Read the worked answer
Use relevant costs only; the remaining fixed overhead of ₹3,60,000 is incurred either way and is irrelevant.
Making:
- Variable cost per unit = 42 + 18 + 15 = ₹75.
- To obtain 24,000 good units at 2% rejection, units started = 24,000 ÷ 0.98 = 24,490 (rounded).
- Variable cost = 24,490 × 75 = ₹18,36,750.
- Avoidable fixed cost = ₹2,40,000.
- Total relevant make cost = ₹20,76,750, i.e. ₹86.53 per good unit.
Buying:
- Purchase 24,000 × 102 = ₹24,48,000.
- Less contribution from Y released capacity = ₹4,00,000.
- Net relevant buy cost = ₹20,48,000, i.e. ₹85.33 per good unit.
Buying is cheaper by ₹28,750 a year (about 1.4%). The recommendation is to buy, but the margin is thin and should be flagged, because a small change in any assumption reverses it. Note that the ₹100 full cost was misleading: ₹15 of the ₹25 absorbed fixed overhead is unavoidable.
2. At what supplier price does the decision reverse?
Read the worked answer
Set the net buy cost equal to the make cost, with p as the price per unit:
24,000p − 4,00,000 = 20,76,750 24,000p = 24,76,750 p = ₹103.20 approximately.
So any delivered price above about ₹103.20 per unit makes in-house manufacture cheaper, and the current ₹102 quote clears the indifference point by only ₹1.20. Given that the supplier's price will not be fixed forever, this is a strong argument for negotiating a price-hold clause or a rebate on volume, and for keeping the in-house line ready rather than dismantling it. If the rejection rate can be brought down from 2% to nil, the make cost falls to 24,000 × 75 + 2,40,000 = ₹20,40,000, which beats buying at ₹102 even without counting Y. Quality improvement in-house therefore changes the answer, which is why a one-year price comparison should not drive a permanent closure decision.
3. List the qualitative factors you would place before the management along with the numbers.
Read the worked answer
Numbers alone cannot carry this decision. Put these alongside:
- Supplier dependability - a single source with no second vendor exposes the line to strikes, price escalation and allocation during shortages; keep a fallback.
- Quality risk - the 2% in-house rejection is costly, but an outside supplier's guarantee must be backed by inspection clauses, rejection rights and penalty terms in the contract.
- Delivery and lead time - floor-space savings are real only if deliveries arrive on schedule; add freight, handling and inventory carrying cost for bought components.
- Workforce - redeployment to product Y must be genuine, otherwise retrenchment cost and morale damage belong in the comparison.
- Market for Y - the ₹4,00,000 contribution assumes the sales manager is right; test it against orders, not forecasts.
- Tax and cash flow - GST credit on purchases improves cash flow against in-house operations.
- Loss of process know-how and future design control if the component leaves the plant.
Recommend buying for one year with a review trigger at ₹103.20, not an irreversible shutdown of the line.