Lakvijaya Foods: Component Make-or-Buy with a Capacity Constraint, and a Break-Even Export Order
Lakvijaya Foods (Pvt) Ltd makes a dairy drink. Component X, used in the drink, costs LKR 360 per unit to make in-house: direct materials 180, direct labour 120 and variable overhead 60. Fixed production overhead of LKR 1.8 million per month is absorbed at LKR 90 per unit on a normal output of 20,000 units. Annual requirement of X is 24,000 units, and each unit uses 0.5 machine hours on a machine with 15,000 hours available per year; the remaining hours currently sit idle. A supplier in Kurunegala offers X at LKR 420 per unit for the full 24,000 units, delivered, with a two-year price lock. If X is bought, the freed machine hours could make a new product earning a contribution of LKR 150 per machine hour, but only up to 10,000 hours; demand beyond that is uncertain. Separately, an exporter offers to buy 4,000 cases of the drink at LKR 700 per case. The normal price is LKR 950, variable cost LKR 620, and the order needs extra packaging and freight of LKR 55 per case plus overtime fixed cost of LKR 100,000. The factory has spare capacity and no other use for it.
1. Carry out the make-or-buy analysis for component X, including the opportunity cost of the released machine hours, and state the decision and its sensitivity.
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Relevant costs of making (annual).
- Avoidable variable cost: 24,000 × 360 = LKR 8,640,000.
- Absorbed fixed overhead of 90 per unit is excluded: the LKR 1.8 million is incurred whether or not X is made, so it is not relevant to the decision.
- Opportunity cost: 24,000 units × 0.5 hours = 12,000 hours released, of which only 10,000 hours can be sold at 150 per hour = LKR 1,500,000.
- Total relevant cost of making = 8,640,000 + 1,500,000 = LKR 10,140,000.
Cost of buying. 24,000 × 420 = LKR 10,080,000, with no contribution from the released hours.
Decision. Buy: net advantage = 10,140,000 − 10,080,000 = LKR 60,000, or treated as 10,080,000 − 1,500,000 = 8,580,000 against 8,640,000.
Sensitivity. The margin is only 60,000, so it is fragile. Break-even opportunity benefit needed = 10,080,000 − 8,640,000 = 1,440,000, i.e. 9,600 of the 12,000 released hours at 150 per hour. If fewer than 9,600 hours can realistically be sold, making is cheaper. Also test any avoidable fixed cost of the in-house line and any redundancy or retraining cost of direct labour – if wages are not avoidable, the case for buying collapses.
2. What qualitative and strategic factors should the board weigh before signing the two-year supply agreement?
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Quality and continuity. X is a core input to a food product. The supplier's capability, food-safety certification, delivery reliability and capacity to absorb 24,000 units are critical. A single-source two-year lock is cheap protection against price rises but exposes the company to a supplier failure; consider a second source, a service-level agreement and stock cover.
Price lock is not a cost guarantee. LKR 420 is fixed for two years, but if inflation or exchange rates move, the supplier may seek renegotiation or cut quality. Check the escalation, quality and termination clauses.
Labour and fixed costs. Direct labour of 120 per unit may not disappear. Confirm with the HR plan whether staff can be redeployed to the new product, otherwise the saving is overstated. Similarly check whether any fixed overhead is genuinely avoidable (supervision, maintenance contract, space).
Use of released capacity. The 150 per hour contribution on the new product must be evidenced by a market study, not just a hope. Only 10,000 of 12,000 hours are assumed sellable, and the decision depends on at least 9,600 hours being sold.
Strategic fit. Making X protects know-how and gives flexibility on recipe changes; buying may be the right long-term choice if the company's competitive advantage is in the drink, not the component. A two-year commitment should be approved on a documented evaluation, not on a 60,000 saving.
3. Evaluate the export order at LKR 700 per case. Would you accept it, and how much room is there to negotiate?
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Incremental analysis (4,000 cases).
- Incremental revenue: 4,000 × 700 = LKR 2,800,000.
- Incremental variable cost: 4,000 × (620 + 55 packaging and freight) = 4,000 × 675 = LKR 2,700,000.
- Contribution before step cost: LKR 100,000.
- Additional overtime fixed cost: LKR 100,000.
- Net incremental result: LKR 0.
The order is exactly at break-even. It earns nothing for the company while consuming overtime, and it carries the risk that the export price becomes a reference price for existing customers or the local distributor.
What is wrong with rejecting it on full cost alone. Using the normal absorption cost (620 plus the company's fixed overhead per case) would show a large loss and reject the order for the wrong reason. With spare capacity, the only costs that matter are the incremental ones – but here the step fixed cost of 100,000 wipes out the contribution.
Negotiation. Break-even price = 675 + 100,000/4,000 = LKR 700. Seek at least LKR 715–725, or get the overtime cost removed by scheduling within normal hours, which would make even 700 attractive (100,000 contribution).
Accept only if a strategic benefit is documented – a referenceable export customer, a market entry that will grow – and the pricing firewall with existing customers is confirmed. Otherwise decline politely and keep the relationship for a later order.