In cost–volume–profit (CVP) analysis, what direct-cost and indirect-cost factors should a business evaluate when deciding whether to outsource a product or service, and what are the key differences between fixed costs and variable costs (with examples) as production or sales volume changes?

What this question is really asking

You are doing two connected CVP tasks: (1) identify which costs matter when comparing “make vs outsource,” and (2) explain how fixed and variable costs behave when volume changes. The key CVP idea is cost behaviour, especially which costs are avoidable versus unavoidable.

(i) Outsourcing decision: direct-cost factors to check

Direct costs are easier to trace to the product or service. When outsourcing, focus on the direct costs you will stop paying (avoidable) versus new direct costs you will start paying.

Direct-cost factors (with plain examples):

• Direct materials saved: If you outsource a chair, you may no longer buy wood, screws, glue.
• Direct labour saved: Wages for the workers who assemble the chair might be removed if those hours are no longer needed.
• Other unit-level costs saved: Packaging per unit, piece-rate payments, power that is clearly tied to each unit.
• Supplier’s per-unit price (the new direct cost): The outsource price per chair, per transaction, or per service hour.
• Quality and wastage effects: If outsourced items have higher defect rates, you may face rework, returns, or warranty costs.
• Delivery and import costs: Freight, insurance, customs duties, and handling charges that come with buying externally.

CVP check: If your relevant direct cost to make is $8 per unit, and a supplier offers $7 per unit, outsourcing looks cheaper at first. But you still must add any extra direct costs like shipping, inspection, and returns.

(i) Outsourcing decision: indirect-cost factors to check

Indirect costs (overheads) are not traced to one unit easily. For outsourcing decisions, the most important question is: Will this overhead actually disappear if we outsource? If it will not disappear, it is not a “saving,” even if it is currently allocated to the product.

Indirect-cost factors (with plain examples):

• Avoidable overhead vs unavoidable overhead:
• Avoidable: A supervisor position that is only needed for that product line.
• Unavoidable: Factory rent that will still be paid even if you outsource.
• Idle capacity and fixed overhead: If machines become idle, depreciation and rent may remain. The “cost per unit” changes, but the total fixed overhead may not.
• Contract management and monitoring costs (new overhead): Staff time for supplier selection, audits, performance tracking, and reporting.
• Inspection and compliance overhead: More incoming quality checks, safety compliance, certifications, or regulatory paperwork.
• IT, ordering, and admin support: Purchasing department time, system changes, invoice processing.
• Risk-related indirect costs: Supply interruptions, longer lead times, and the cost of holding extra safety stock.

Quick rule: Ignore allocated overhead unless it is avoidable. Decisions should be based on relevant costs, not accounting allocations.

(ii) Fixed costs vs variable costs: behaviour and examples

The easiest way to explain this is to separate total cost behaviour from cost per unit behaviour.

Fixed costs

• Meaning: Fixed costs stay the same in total within a relevant range, even if production changes.
• Examples: Factory rent per month, salaried manager, insurance, straight-line depreciation.
• Behaviour with volume:
• Total fixed cost: stays constant (for example, rent is $10,000 per month).
• Fixed cost per unit: falls as units increase.

Example: If rent is $10,000:

• At 1,000 units: fixed cost per unit $= \frac{10{,}000}{1{,}000} = 10$
• At 2,000 units: fixed cost per unit $= \frac{10{,}000}{2{,}000} = 5$

Variable costs

• Meaning: Variable costs change in total in proportion to activity (units made or sold).
• Examples: Direct materials, sales commission per sale, piece-rate labour, packaging per unit.
• Behaviour with volume:
• Total variable cost: increases as units increase.
• Variable cost per unit: usually stays about the same (for example, $5 per unit).

Example: If materials are $5 per unit:

• At 1,000 units: total variable cost $= 1{,}000 \times 5 = 5{,}000$
• At 2,000 units: total variable cost $= 2{,}000 \times 5 = 10{,}000$

How this links back to CVP decisions

CVP analysis often uses:

• Contribution per unit $= \text{Selling price} - \text{Variable cost per unit}$
• Profit $= \text{Contribution} - \text{Fixed costs}$

So, when outsourcing, you mainly ask: does outsourcing change variable costs per unit, fixed costs, or both? And which overheads are actually avoidable?