Make or buy with constrained machine hours and an opportunity cost
Hamza Engineering assembles pumps and needs 12,000 units of component X each year. An outside supplier will supply all 12,000 at Rs 850 each, price fixed for two years; the supplier is quality-certified. The internal cost card for X shows: direct material Rs 320; direct labour 4 hours at Rs 45 = Rs 180; variable overhead Rs 60; fixed overhead Rs 200. Of the fixed overhead, Rs 120 is an avoidable supervisor and maintenance cost; Rs 80 is apportioned factory rent that continues either way. Each X requires 3 machine hours. The machines are currently used 30,000 hours a year to make component Z, which earns contribution of Rs 120 per machine hour. Total capacity is 40,000 hours; demand for Z is capped at 30,000 hours and will not grow. The production manager argues that making X costs Rs 760, so buying at Rs 850 is clearly wrong.
1. Calculate the relevant cost of making X and decide whether to make or buy.
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Relevant make cost per unit: DM 320 + DL 180 + VOH 60 + avoidable fixed 120 = Rs 680. The Rs 80 apportioned rent is not avoidable, so it is irrelevant to the decision and must not be added; the production manager's Rs 760 wrongly includes it and wrongly ignores the constraint.
Machine hours needed: 12,000 x 3 = 36,000. Capacity is 40,000; current Z use is 30,000; spare capacity is 10,000 hours. So only 26,000 hours of Z must be displaced, not all 36,000.
Opportunity cost = 26,000 x Rs 120 = Rs 3,120,000, or Rs 260 per unit of X. Relevant cost of making = 680 + 260 = Rs 940. Buying at Rs 850 saves Rs 90 per unit, or Rs 1,080,000 a year.
Decision: buy, subject to the qualitative factors being acceptable. The common error is to apply Rs 360 (3 hours x 120) as the opportunity cost; that assumes no spare capacity and overstates the cost of making by Rs 100 per unit.
2. At what supplier price would the decision reverse, and how would the answer change if machine time per unit of X fell to 2 hours?
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The break-even purchase price is the relevant make cost, Rs 940 per unit. At Rs 950, making saves Rs 10 per unit, or Rs 120,000 a year; that is a thin margin against the risks of in-house production, so qualitative factors would dominate.
If machine time per unit falls to 2 hours, hours needed are 24,000. Spare capacity is 10,000, so displaced Z hours are 14,000. Opportunity cost = 14,000 x 120 = Rs 1,680,000, or Rs 140 per unit. Relevant make cost = 680 + 140 = Rs 820, below Rs 850, so the decision reverses to make, saving Rs 30 per unit or Rs 360,000 a year.
The lesson is that the make-or-buy answer is driven by the hours displaced, not by the hours used. The calculation must be redone whenever the process changes, Z demand changes, or the contribution per machine hour changes. If Z's contribution falls to Rs 80 per hour, the opportunity cost falls and making X becomes cheaper; if Z demand grows to use all 40,000 hours, the opportunity cost becomes Rs 360 per unit and buying becomes more attractive.
3. What non-financial and strategic factors should accompany the numerical recommendation?
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A single supplier creates dependency risk: delivery failure stops pump assembly, and a two-year fixed price may not survive if the supplier renegotiates. Test the supplier's capacity to serve other customers, its financial standing, and the enforceability of the quality certification. The saving of Rs 1,080,000 is only 10.6% of the relevant make cost, so a modest price rise or a quality failure wipes it out.
Loss of in-house capability matters. If X is close to Hamza's core competence, outsourcing erodes process knowledge and makes it costly to bring production back. Redundancy and labour relations costs of reducing the workforce should be quantified; they are relevant one-off costs if the decision is implemented.
Cost inflation and exchange rates affect the comparison: the internal cost includes labour and overhead that will rise, while the supplier price is fixed for two years. That favours buying. Conversely, if the supplier's material is imported, currency movement could force a price review.
Finally, consider whether Z's contribution of Rs 120 per hour is sustainable. If Z is a declining product, the opportunity cost falls and making X becomes the better choice. Present the recommendation with a sensitivity range, not a single point estimate.