Make or Buy Decision

Facing Competition Through Cost Leadership

• Firms achieve cost leadership by:
  • Outsourcing non-core activities
  • Restricting activities to core components/functions
• Helps improve cost competitiveness and strategic focus

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When to Outsource? (Decision Criteria)

• Use marginal costing structure to decide
• Key principle: Only relevant costs should influence decision

Fixed costs are excluded unless they can be eliminated.

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Case Study: Voltage Stabilizer Outsourcing Decision

Background

• Company manufactures:
  • Refrigerators, washing machines, TVs, air-conditioners
• Internal division produces voltage stabilizers
• Components are transferred at cost + 20% markup (Transfer Price)

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Current Internal Cost Structure (per unit):

Cost Component	Amount (₹)
Material	400
Labour	50
Variable Overhead	100
Total Variable Cost	550
Fixed Cost (exclusive)	60
Fixed Cost (allocated)	20
Total Product Cost	630
Mark-up (20%)	126
Transfer Price	756

• Capacity: 400,000 units
• Current Production: 200,000 units

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KS Electronics Offer:

Volume	Price per Unit (₹)
200,000 units	620
300,000 units	600

• Committed for 3 years (adjustable for RM price rise)

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Cost Comparison & Decision Making

Relevant Cost (Internal):

• Total relevant cost per unit = Variable Cost + Exclusive Fixed Cost
  = ₹550 + ₹60 = ₹610
  (Allocated fixed cost of ₹20 is irrelevant—it will be incurred anyway)

Decision for 200,000 Units:

• KS Offer = ₹620
• Internal Relevant Cost = ₹610

❌ Not cost-effective to outsource

Decision for 300,000 Units:

• Exclusive fixed cost/unit ↓ to ₹40 (due to higher volume)
• Relevant Cost = ₹550 + ₹40 = ₹590
• KS Offer = ₹600

❌ Still cheaper to produce internally

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Impact of One-Time Cash Flow from Asset Sale

Scenario:

• Sell plant/machinery = ₹600 lakhs
• Cost of capital = 15%
• Annual opportunity cost = ₹600L × 15% = ₹90L
• Per unit (300,000 units) = ₹90L ÷ 2L = ₹45

🔁 Add ₹45/unit opportunity cost to earlier internal cost: ₹610 + ₹45 = ₹655
✅ Now, outsourcing at ₹620 becomes cost-effective

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📌 Key Learnings

• Relevant Costs include:
  • Variable cost
  • Fixed cost only if avoidable
  • Opportunity cost (e.g., asset sale)
• Irrelevant Costs:
  • Allocated fixed costs (continue regardless of decision)
• Marginal costing helps avoid misleading full-cost comparisons
• Outsourcing decisions may need multiple iterations and thorough analysis

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