Make or buy decisions: meaning, quantitative and qualitative considerations

Meaning of make or buy decisions

A make or buy decision is the choice between producing a component, product or service within the organisation and buying it from an outside supplier (outsourcing). Firms face it when they plan a new product, when a supplier offers a lower price, when capacity is idle or short, or when they review whether to continue making an item in-house. The decision is based on relevant costs, the costs that differ between the two alternatives, together with qualitative factors. Example: a component costs ₹120 to buy; making it needs material ₹50, labour ₹30 and variable overhead ₹20, while fixed costs of the plant continue either way. With idle capacity, the relevant cost of making is ₹100, so making saves ₹20 a unit.

Quantitative considerations

1. Relevant cost of making. Variable (marginal) cost, direct materials, direct labour, variable overheads, plus any fixed costs that would be incurred only if the item is made (special tools, extra supervision). Fixed costs that continue either way are irrelevant.
2. Price of buying. The supplier's price plus transport, inspection and ordering costs.
3. Spare capacity. If capacity is idle, the item should be made when its marginal cost is below the purchase price.
4. Opportunity cost. If capacity is fully used, making the item means giving up other work; the contribution lost is added to the cost of making. The two costs must also be compared like for like: the same quantity, to the same specification and quality.
5. Key factor. Where a resource is scarce, compare the contribution per unit of that resource from the item with that from other products.
6. Volume. At low volumes buying may be cheaper; above an indifference point making may be cheaper because fixed costs are spread.
7. Investment needed. New machinery for in-house manufacture must be evaluated by capital budgeting.

Qualitative considerations

1. Quality: can the supplier meet the required specification consistently, and can the firm itself hold that quality if it makes the item in-house?
2. Reliability and capacity of supply: whether the supplier can produce the full quantity needed, deliver on time, and keep supplying through strikes or shortages.
3. Control and secrecy: protecting designs, processes and trade secrets.
4. Dependence on the supplier: risk of price increases later or of the supplier becoming a competitor.
5. Effect on employees: buying may cause layoffs and affect morale; making may need new skills.
6. Flexibility: buying gives flexibility to change suppliers and designs.
7. Core competence: firms often make what they are best at and buy the rest.
8. Long-term relationships and goodwill with suppliers and customers.

Conclusion

A make or buy decision compares the relevant cost of making, including any opportunity cost, with the full cost of buying, and then weighs quality, supply, control and strategic factors before a final choice.