Outsourcing Overflow Production

When internal production is already constrained, the choice may be how much of each product to outsource rather than whether to outsource the entire operation. A contribution-per-unit ranking can miss the relevant tradeoff. If both products will be sold either way, compare the extra cost of outsourcing each one and how much scarce internal capacity is required to avoid that extra cost.

Worked decision model

Assume customer demand is 300 units of A and 200 units of B. Producing A internally requires 0.2 machine hour and $12 of variable cost per unit; an outside supplier charges $17 per delivered A. B requires 0.4 hour and $20 internally; outside delivered cost is $26. There are only 100 internal machine hours. Producing all demand internally would require 140 hours, so at least part of the workload must move outside or another feasible capacity option must be evaluated.

Internal production saves $5 per A compared with buying, using 0.2 hour, or $25 per scarce machine hour. It saves $6 per B using 0.4 hour, or $15 per scarce hour. Although B has the larger saving per unit, A has the larger saving per constrained hour. Making all 300 A internally uses 60 hours. The remaining 40 hours can make 100 B, leaving 100 B to outsource.

Under that plan, internal A costs $3,600, internal B costs $2,000, and outsourced B costs $2,600, totaling $8,200 before any supplier setup. An alternative that makes all 200 B internally uses 80 hours, leaving capacity for 100 A and requiring 200 outsourced A. It costs $4,000 plus $1,200 plus $3,400, or $8,600. The first allocation is $400 lower under the stated unit costs and equal-quality assumption.

Now add a $500 setup charge that applies only if any B is outsourced, while outsourced A has no setup charge. The first plan rises to $8,700 and the second remains $8,600, reversing their order. The unit-saving-per-hour rule must therefore be checked against supplier entry costs and whole production choices. If both outsource options have setup charges, include every charge actually triggered by the complete plan rather than spreading it over an assumed order quantity that may never occur.

Use delivered supplier costs including the inspection, logistics, and coordination that differ from internal work. Existing fixed factory costs remain in the overall business result but are omitted from this allocation comparison when unchanged. Internal rework rates, supplier minimums, and demand caps can change the feasible schedule. Confirm that outsourced goods meet the same customer requirement and arrive within the same period. This worksheet compares modeled alternatives; it does not establish supplier quality, available capacity, or a guaranteed lower total operating cost.

Apply and verify the decision

1. Build comparable delivered costs

   Include different inspection, shipping, and coordination work in the supplier route before calculating the outsourcing penalty.

2. Allocate scarce hours

   Rank the avoided outsourcing cost per constrained hour, respect customer demand, and verify that the proposed internal quantities fit capacity.

3. Recheck complete supplier orders

   Add setup fees, minimums, and batch restrictions to each feasible plan; compare totals after these discontinuous costs are included.

Method reference: OpenStax: Making or Buying a Component. Accessed October 22, 2026. The reference supports the accounting concept; all scenario prices, rates, probabilities, and worked calculations are independently constructed hypothetical examples.