Case 091Costing, pricing and unit economicsWarm up

A parts maker produces a component at a full cost of Rs 420 a unit, including Rs 100 of allocated fixed overhead, and a supplier offers it at Rs 360. The freed capacity could earn Rs 30 lakh. Make or buy?

The situation

Chakradhar Auto Components, an invented maker of brake assemblies, machines a bracket in house. Its cost sheet shows Rs 420 a unit: materials Rs 200, direct labour Rs 80, variable overhead Rs 40 and allocated fixed factory overhead Rs 100. It makes 2 lakh units a year.

A supplier offers to deliver the same bracket, to the same quality, at Rs 360 a unit. If Chakradhar stops making the bracket, the fixed overhead does not go away, but the freed machine time could be used to make a different part that would earn Rs 30 lakh a year of contribution. The plant head says buying is obvious because Rs 360 is below Rs 420.

Your task

Should Chakradhar make or buy, by how much, and at what supplier price would it be indifferent?

Quick check

Which cost per unit should be compared with the Rs 360 supplier price?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Make. Making costs Rs 320 a unit in costs that would actually stop, against Rs 360 to buy, so buying would cost Rs 80 lakh more a year on 2 lakh units; after the Rs 30 lakh the freed capacity could earn, making still wins by Rs 50 lakh. The Rs 100 of fixed overhead is paid whether the bracket is made or bought, so it belongs in neither column. Chakradhar is indifferent at a supplier price of about Rs 335. The plant head's comparison sets a cost that includes rent against a price that does not.

Step 1Which costs belong in the decision?

Suppose you cook at home for Rs 80 a meal in ingredients and gas, and a tiffin service offers meals at Rs 100. If someone adds your kitchen's share of the house rent, Rs 40 a meal, home cooking looks like Rs 120 and the tiffin looks cheaper. But the rent is paid whether you cook or not. Only a cost that stops when you stop making the part is a cost of making it; the rest is being allocated, not caused. For Chakradhar, materials, labour and variable overhead, Rs 320 a unit, stop. The Rs 100 of allocated fixed overheadA share of factory costs such as rent, supervision and depreciation spread across products by a formula, which the product does not cause and which does not stop if the product does. does not, so the bracket's relevant costThe costs that differ between the choices being compared; everything else is the same under both and can be ignored. is Rs 320, not Rs 420.

Making the bracket costs Rs 320 a unit in costs that would stop, against Rs 360 to buy, so on 2 lakh units buying costs Rs 80 lakh more a year, and even after the Rs 30 lakh the freed capacity could earn, making is cheaper by Rs 50 lakh.

Step 2How does the freed capacity change the answer?

Buying frees machine time, and machine time that can earn money is worth something. The Rs 30 lakh of contribution from the other part is an opportunity costThe value of the best alternative use of a resource, which you give up by using the resource as you do now. of continuing to make the bracket, so it is added to the buy side of the comparison. Buying costs Rs 720 lakh a year against Rs 640 lakh to make, a gap of Rs 80 lakh in favour of making; the Rs 30 lakh narrows it to Rs 50 lakh. Making still wins. If the alternative part could earn Rs 80 lakh or more, the answer would flip, which is the first thing to check about the Rs 30 lakh: is it a contribution the sales team has actually sold, or a figure from a brochure?

The relationship

\text{Buy} - \text{Make} = (360 - 320) \times 2 - 30 = 80 - 30 = 50 \text{ lakh} \qquad P^* = 320 + \frac{30}{2} = 335

360 - 320	supplier price less the per-unit cost that stops if the part is bought
2	annual volume in lakh units
30	contribution the freed capacity could earn, Rs lakh
P*	the supplier price at which Chakradhar is indifferent

What it says in wordsBuying costs Rs 50 lakh a year more than making once the freed capacity's earnings are counted, and the supplier would have to come down to about Rs 335 before buying matched making.

Rs lakh a year	Make	Buy
Materials, labour, variable overhead	640	0
Supplier price	0	720
Contribution from freed capacity	0	-30
Fixed overhead	200	200
Total	840	890

With the Rs 200 lakh of fixed overhead shown in both columns, where it belongs, making the bracket costs Rs 840 lakh a year against Rs 890 lakh to buy, a Rs 50 lakh advantage to making.

Step 3What would change your mind?

Two things, and both are questions for the plant rather than the spreadsheet. If part of the fixed overhead is avoidable, say a supervisor and a rented bay worth Rs 40 a unit that could go, the make side gains Rs 80 lakh of cost and buying becomes cheaper by Rs 30 lakh. Fixed is a description of how a cost behaves with volume, not a promise that it can never be removed. And the comparison assumes the supplier matches Chakradhar on quality, delivery and price stability. A Rs 360 quote that becomes Rs 380 next year, or a supplier whose late delivery stops a brake assembly line, costs more than the Rs 50 lakh in play. The plant head's instinct that Rs 420 against Rs 360 settles it is the error the question is built to catch.

Where candidates lose it

The common loss is comparing full cost with the supplier price: Rs 420 against Rs 360 says buy and save Rs 120 lakh. The Rs 100 of overhead in the Rs 420 is still paid after the part is bought, so the saving is imaginary and the decision costs the company Rs 50 lakh a year.

The second loss is forgetting the freed capacity. A candidate who stops at Rs 320 against Rs 360 has the right direction but the wrong margin; the opportunity cost belongs in the answer, and in this case it narrows the gap without closing it.

What the interviewer asks next

The supplier offers Rs 330 if Chakradhar signs a three-year contract. What would you want to know before signing?
How would you treat the Rs 100 of overhead if half of it were depreciation on a machine that could be sold?
The alternative part's Rs 30 lakh requires a Rs 20 lakh tooling investment. Does that change the answer?

Company names and figures are illustrative.