Make or Buy at Ravenshaw Components
Ravenshaw Components Ltd makes 24,000 units of a sub-assembly each year for use in its own assembly line. The cost sheet shows, per unit: direct material Rs 86, direct labour Rs 54, variable overhead Rs 31, and fixed overhead absorbed at Rs 70. Total fixed overhead absorbed by the sub-assembly is therefore Rs 16.8 lakh. A supplier offers to supply all 24,000 units at Rs 215 each. The works accountant estimates that if the sub-assembly is discontinued, 60 per cent of the absorbed fixed overhead would be eliminated; the remaining 40 per cent, mainly factory rent and the plant manager's salary, would continue. Two supervisors costing Rs 3.6 lakh a year, included in the absorbed fixed overhead, would be redeployed to another department at the same pay. The vacated floor space can be rented out for Rs 2.4 lakh a year. Bought-out units would require incoming inspection costing Rs 18 per unit, an activity not currently performed. The supplier has indicated an 8 per cent price escalation after the first year, and the requirement is expected to remain at 24,000 units for five years.
1. Prepare the relevant cost comparison for year 1 and state the decision, showing clearly which figures in the cost sheet you excluded and why.
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Excluded first. The per-unit fixed overhead of Rs 70 is an absorption figure, not a differential cost. Only the avoidable portion is relevant: 60 per cent of Rs 16.8 lakh = Rs 10,08,000. The continuing 40 per cent (Rs 6,72,000) is incurred either way. The Rs 3.6 lakh supervisors' cost is inside fixed overhead and is irrelevant because those employees are redeployed at the same pay - no cash is saved. Direct material, labour and variable overhead are all avoidable and therefore relevant.
Cost to make (relevant, year 1)
- Variable cost: 24,000 × (86 + 54 + 31) = 24,000 × 171 = Rs 41,04,000
- Avoidable fixed overhead = Rs 10,08,000
- Opportunity cost of floor space (rent forgone) = Rs 2,40,000
- Total = Rs 53,52,000
Cost to buy (year 1)
- Purchase: 24,000 × 215 = Rs 51,60,000
- Incoming inspection: 24,000 × 18 = Rs 4,32,000
- Total = Rs 55,92,000
Decision: making is cheaper by Rs 2,40,000 in year 1, so reject the offer as it stands. Note how narrow the margin is - 4.5 per cent of the make cost - and that the conclusion rests on the rental opportunity being realisable.
2. Compute the supplier price at which the company would be indifferent, and extend the analysis to year 2 given the 8 per cent escalation.
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Indifference price, year 1. Set the buy cost equal to the relevant make cost, with inspection retained:
24,000P + 4,32,000 = 53,52,000 24,000P = 49,20,000 P = Rs 205 per unit
The offer at Rs 215 is Rs 10 above indifference, which is why the make option wins by 24,000 × 10 = Rs 2,40,000. In other words, the supplier must come down by about 4.7 per cent before the proposal is even at par.
Year 2. Escalated price = 215 × 1.08 = Rs 232.20. Buy cost = 24,000 × 232.20 = Rs 55,72,800, plus inspection Rs 4,32,000 = Rs 60,04,800. Make cost remains Rs 53,52,000 (assuming stable input costs and continuing rental). The make advantage widens to Rs 6,52,800.
Sensitivity. The result is more fragile than it looks on two counts. (i) If the floor space cannot in fact be let, make cost falls to Rs 51,12,000 and the make advantage doubles to Rs 4,80,000 - so the rental is a benefit of making, not a risk. (ii) The break-even rental at which buying becomes preferable is Rs 4,80,000, i.e. the make option loses its advantage if the space can be let for more than that. (iii) If volume rises, the make option improves, because the buy cost is wholly variable at Rs 233 per unit against Rs 171 to make.
3. What non-financial and strategic factors should the board weigh, and how should they be presented alongside the numbers?
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The numbers give a Rs 2.4 lakh answer on a Rs 53 lakh decision - under 5 per cent - which is within the error band of the estimates themselves. Strategic factors therefore legitimately carry weight, but they must be presented transparently rather than used to override the arithmetic.
Factors to record: single-source dependence - the entire sub-assembly would come from one supplier for five years, with no in-house capability retained; loss of flexibility on design changes, since bought-out units lock in a specification; workforce consequences - the two supervisors are redeployed now, but assembly-line operators are not addressed, and industrial-relations cost is real even if not in the cost sheet; quality and delivery risk - incoming inspection at Rs 18 per unit catches defects but does not prevent line stoppage; supplier financial stability over a five-year term with an 8 per cent annual escalator that is contractually one-sided; and capability erosion, since once the process is discontinued, re-entry is expensive.
Presentation: put the quantitative comparison first, with the Rs 205 indifference price and the sensitivity table, then a short qualitative risk column, then a recommendation. The defensible recommendation is to retain in-house manufacture and, if the supplier wishes to be considered, invite a counter-offer at or below Rs 205 with a capped escalation clause and a dual-sourcing arrangement - which converts a binary make-or-buy into a risk-managed position.