Pricing to an OEM, make-or-buy and operating leverage
Cost-plus quotes, price-downs and annual price reductions, the cost cut needed to hold margin, relevant costs for make-or-buy, and degree of operating leverage.
By Manoj Sahukar· October 2026 · 14 min read
How numbers are rounded on these pages. Calculations are done at full precision and rounded only at the end, half up. Rupee amounts are rounded to the nearest rupee unless shown with paise, in which case to the nearest paisa. Percentages are shown to two decimal places; payback periods in years, and ratios such as degree of operating leverage, to two decimal places. Quantities you must start, buy or sell to reach a target are rounded up to the next whole unit or kg. Depreciation uses textbook straight line and written down value methods, not the rates or lives set by tax or company law. All examples and quiz questions are Hypothetical: they show the method, not real prices or rates.
Pricing as a supplier to an OEM
An OEM (original equipment manufacturer) is the brand that designs, assembles and sells the finished product under its own name, such as a car or appliance maker. As a component supplier you usually quote cost-plus: your full cost per part plus a markup. The OEM will often ask for a price-down (a one-time cut) or an annual price reduction (a percentage cut every year of the contract, often called an annual price-down).
Annual reductions compound: 3% a year for three years is not 9%. To keep your margin, your own cost must fall by the same percentage each year, through better yield, cycle time or material buying. If cost stays put, the cut comes straight out of your profit. Contract terms differ by OEM and part.
The standard formulas
Cost-plusCost-plus price = Full cost per unit × (1 + Markup %)
Price reductionsPrice after a price-down = Price × (1 − Cut %)Price after n annual reductions = P × (1 − r)n
Cost cut neededKeep the same margin %: New cost = New price × (1 − Margin %)Keep the same rupee profit: Cost must fall by the rupee price cut
Terms used
OEM (original equipment manufacturer)
The brand that sells the finished product under its own name and buys parts from suppliers.
Tier 1 supplier
A supplier that sells directly to the OEM; tier 2 sells to tier 1.
Cost-plus pricing
Price set as cost plus a markup percentage.
Price-down
A reduction in the part price demanded by the customer.
Annual price reduction
A percentage price cut applied each contract year, compounding on the previous year's price.
Worked examples
HypotheticalBasicA cost-plus quote
A supplier's full cost for a pressed bracket is ₹200; it quotes a 15% markup.
To keep the 13.04% margin, cost must fall by the same 8.73%: ₹200 × 0.973 = ₹182.53, a cut of ₹17.47 a part
Make or buy
Should you make a part yourself or buy it from another supplier? Compare the buy price with the relevant cost of making: only the costs that would actually change. That is the variable cost, plus any fixed cost you would avoid by buying (a supervisor you would not need, a tool you would not rent), plus any opportunity cost: the contribution you give up if making this part uses capacity that could make something else.
Fixed overheads allocated to the part but paid anyway (factory rent, the plant manager's salary) are not relevant. Also weigh things not in the numbers: quality, delivery reliability, dependence on one supplier, and whether the OEM must approve a change of source.
The standard formulas
Relevant cost of making = Variable cost + Avoidable fixed costs + Opportunity cost
DecisionMake if Relevant cost of making < Buy price × Units (plus any buying costs)
Indifference pointVolume at which make and buy cost the same = Avoidable fixed costs of makingBuy price − Variable cost of making
Terms used
Relevant cost
A future cash cost that differs between the options.
Avoidable cost
A cost that would not be incurred if you chose the other option.
Unavoidable (committed) cost
A cost you pay whichever option you choose; irrelevant to the decision.
Opportunity cost
The benefit given up by choosing one use of a resource over another.
Worked examples
HypotheticalBasicFull cost misleads
A bracket costs ₹60 variable (material, labour, variable overhead) plus ₹12 of allocated factory overhead that is paid anyway: full cost ₹72. A supplier quotes ₹68.
Full cost says buy (₹68 < ₹72), but the ₹12 stays whichever you choose.
Relevant cost of making = ₹60; making saves ₹8 a part
HypotheticalIntermediateAn avoidable fixed cost
20,000 brackets a year. Making them needs a dedicated supervisor costing ₹2,40,000 a year, avoidable if you buy.
Indifference point = ₹2,40,000 ÷ (₹68 − ₹60) = 30,000 brackets a year; above that, making is cheaper
HypotheticalAdvancedCounting the opportunity cost
A different part: 10,000 a year, variable cost to make ₹110, supplier price ₹125. If bought, the freed machine time could make another product with ₹2,00,000 a year of contribution.
Buying is cheaper by ₹50,000, although on variable cost alone making looked ₹1,50,000 cheaper
Operating leverage
A plant with heavy fixed costs (automation, big presses) and low variable cost per unit makes a lot of extra profit when sales rise, and loses profit fast when they fall. Operating leverage measures this. The degree of operating leverage (DOL) tells you roughly how many per cent operating profit moves for each 1% change in sales, if prices and the cost structure stay the same.
High leverage is good in a growing market and risky when an OEM cuts its schedules. DOL also changes as sales change, so it is a snapshot at today's level.
Quiz: pricing to an OEM, make-or-buy and operating leverage
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