The grey is likely aluminum, probably from the backplate. Stop running it! Check inside. If it's eating the backplate, you'll burn out a lot of glowplugs. You're better off replacing the case or other needed parts, at the current price of glowplugs.
I think your 1/8" estimate is probably much exaggerated, but I'd fix it or send it to be fixed, or better yet, just buy a new one. I know they're hard to find, but sometimes they can be. Keep your old one for spare parts, just in case you (or somebody you know) needs what's left. I had two NIB, but sold them a few weeks ago.
Steve