Question 7.A.21: Now assume that Shah Ltd (Activity 7.20) has no spare capaci...

Accounting and Finance for Non-Specialists

Now assume that Shah Ltd (Activity 7.20) has no spare capacity, so it can only produce the component internally by reducing its output of another of its products. While it is making each component, it will lose contributions of £12 from the other product. Should the component be subcontracted or produced internally?

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The answer is to subcontract. In this case, both the variable cost of production and the opportunity cost of lost contributions must be taken into account.
Thus, the relevant cost of internal production of each component is:

	£
Variable cost of production of the component	15
Opportunity cost of lost production of the other product	$\underline{12}$
	$\underline{27}$

This is obviously more costly than the £20 per component that will have to be paid to the subcontractor.

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