Make or Buy Decision

A make or buy decision is the choice a business faces between producing a part, product or service itself and buying it from an outside supplier. Manufacturers face it when deciding whether to machine their own components, and service firms face it when deciding whether to run payroll, IT or customer support in-house or outsource them. The decision is a standard application of relevant cost analysis in managerial and cost accounting.

The financial question is which option leaves the business with lower total costs, or higher profit, from now on. Only costs and revenues that differ between the two options are relevant. Past spending that cannot be recovered, and costs that will continue whichever option is chosen, are ignored. Beyond the numbers, the decision also depends on quality, reliability of supply, control over know-how and the best use of the company's own capacity.

• Relevant: direct materials, direct labor and variable costs of production that would be avoided by buying, and the supplier's price, including freight and inspection.
• Relevant: fixed costs that would actually disappear if production stopped, such as a supervisor's salary or equipment lease that could be ended.
• Irrelevant: allocated common costs, such as a share of factory rent or head office expenses, that would continue regardless.
• Irrelevant: sunk costs, such as money already spent on machinery that has no resale value.
• Relevant: the opportunity cost of capacity, meaning the profit the company could earn by using the freed space and staff for something else.

A bicycle maker produces 20,000 gear assemblies a year. Its cost records show a unit cost of $46: direct materials $18, direct labor $12, variable overhead $6 and allocated fixed costs of $10. A supplier offers to sell the assemblies for $40 each. At first sight buying looks cheaper by $6 a unit.

Investigation shows that of the $10 of fixed cost per unit, only $3 (a dedicated supervisor and equipment lease, $60,000 a year) would be avoided if production stopped. The remaining $7 is allocated factory overhead that would stay. The relevant comparison is:

Here $\text{Variable cost per unit}$ is $36, $\text{Units}$ is 20,000 and $\text{Avoidable fixed costs}$ is $60,000. The relevant cost to make is $720,000 plus $60,000, which is $780,000. The cost to buy is 20,000 times $40, or $800,000. Making the part in-house is therefore $20,000 a year cheaper.

Now suppose the freed space could be rented to another company for $50,000 a year. That rent is an opportunity cost of making, raising the relevant cost of making to $830,000. Buying then becomes $30,000 cheaper, and the decision reverses.

• Quality and reliability: an outside supplier may have better or worse quality control and delivery performance.
• Strategic control: core technology or processes that give the company its competitive edge are often kept in-house even if buying is cheaper.
• Supplier dependence: relying on one supplier can expose the business to price rises, shortages or the supplier's failure.
• Capacity and flexibility: buying lets a company scale up quickly without investing in new plant, and can turn fixed costs into variable ones.
• Learning and scale: a specialist supplier may benefit from economies of scale that the company cannot match.

The most frequent error is comparing the supplier's price with a full unit cost that includes allocated overhead, which makes in-house production look more expensive than it is and can lead to outsourcing that does not actually save money. A second error is ignoring hidden costs of buying, such as freight, import duties, quality inspection and the staff time needed to manage the supplier. Many firms now look at the total cost of ownership over several years and treat the decision as part of capital budgeting when it involves buying or selling equipment, discounting the cash flows with techniques such as net present value (NPV). A structured cost-benefit analysis helps weigh the qualitative factors alongside the numbers, and incremental cost analysis keeps the focus on what actually changes.