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Make-or-Buy Decisions
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Make-or-buy decisions involve the assessment of whether an organization should continue
manufacturing a product or service ‘in-house’, or if it should just buy those from an outside supplier.

Why Outsource?

If an organization is already manufacturing the entire product internally without involving any
outside contractor, why should it outsource any of its business processes?

Outsourcing can improve the pro tability of businesses by:

Enabling businesses to focus on their core products by delegating non-critical processes to



external organizations;

Bene ting from a lower cost o ered by outside suppliers that are more e cient in producing
certain products or services;
Overcoming production constraints caused by a shortage of internal resources;
Procuring products and services of a higher quality.

Qualitative Analysis

Organizations need to weigh the short-term nancial impact of outsourcing against the long term
consequences.

Several factors in uence make-or-buy decisions.

Quality
Will external sourcing compromise the quality of the nal product?
Can a business enhance the quality of its products by hiring a specialist?
Reliability:
Is an external supplier better equipped to deal with sudden uctuations in production
requirements?
Will d l ti th l f b i k it l bl t l di ?
 Will delegating the supply of a business process make it vulnerable to supply dips?
Control:
How important is a speci c process, product, or component, to the core business?
Will giving up the control of a process make the business less exible?
Capacity
How will the organization deal with idle resources if it decides against manufacturing in-
house?
Will outsourcing cause redundancies and how will they impact the organization?
Competitiveness
How will outsourcing a ect the pro tability of business?
Is the cost of buying a component or process from outside lower than the internal
production cost?
Can outsourcing help the business improve its competitiveness by channeling its focus to
the key areas?


Quantitative Analysis

Make-or-buy decisions must be based on the relevant cost of each option.

Relevant costs in make-or-buy decisions include all incremental cash ows.

Any cost that does not change as a result of the decision should be ignored such as depreciation
and indirect xed costs.

Calculating the relevant cost is the rst step in nding the most cost-e ective option.

Following are examples of relevant costs in make-or-buy decision

Relevant Examples
Costs

Variable costs Cost of labor involved in the production.

Cost of material used in manufacturing.

 Variable production overheads such as the cost of electricity used in
production.

Direct xed Rent of production facility.

costs Salary of factory supervisor.

Opportunity Rental income from machinery that is given up for manufacturing

cost in-house.

Examples of irrelevant costs in make-or-buy decisions are as follows: 

Non- Examples
Non-
Relevant Examples
Relevant
Costs
Costs

Indirect xed General and administrative expense.

costs

Non-cash Depreciation.
expenses

Sunk costs Cost of machinery already paid.

Committed The rental expense of a factory building whose lease agreement does
costs not allow termination until the end of the lease term.

Once we sort out the relevant costs in the make-or-buy decision, we need to nd which option
minimizes the total cost.

The approach to nding the optimum solution in an outsourcing problem depends on the number
of limiting factors.

Number of Make or Buy?

limiting factors

0 Compare the relevant cost of in-house production with the cost of

acquiring product or service externally.

If the internal cost exceeds the external price, it is better to buy. 

Number1of IfMake
the internal
or Buy?cost exceeds the external price, it is better to buy.
limiting factors
If the external price exceeds the internal cost, it is better to make.
Production priority is given on the basis of incremental cost per

limiting factor.

≥2 The optimum solution can be found by using linear programming.

Example

Phone Inc. is a manufacturer of cell phones. Until now the company has manufactured all phone
accessories in-house.

The company CFO is wondering if it can reduce the manufacturing cost of cell phones by
outsourcing the production of 3 accessories: charger, battery, and earphone.

The accountant has forecast the following information for the next year
The accountant has forecast the following information for the next year.

Charger Battery Earphone

Sales (Units) 10,000 10,000 10,000

Labor hours / unit 0.5 0.25 0.2

Machine hours / unit 0.10 0.15 0.12

Cost of Production $ $ $

Variable cost Charger Battery Earphone

Direct labor 20,000 30,000 40,000

Direct materials 10,000 20,000 30,000

Variable overheads 10,000 10,000 10,000

Fixed cost

Direct xed cost

Depreciation 10,000 10,000 20,000

Salaries 20,000 10,000 10,000

Rent 10 000 20 000 20 000

 Rent 10,000 20,000 20,000

Indirect xed cost

 Non-manufacturing overheads 10,000 20,000 30,000

Total cost 100,000 80,000 120,000

Direct xed costs relate speci cally to each component. Non-manufacturing overheads represent
the allocated share of head o ce expenses.

Outsource Inc. has supplied the following quotation for the supply of the three components.


Charger
Charger Battery
Battery Earphone
Earphone

Sales (Units) $ $ $

Price 10 4 8

Based on quantitative analysis:

A. How many units of each component should be outsourced?

B. If only 3,000 labor hours are available, how many units of each component should be produced
internally or outsourced?

C. If only 3,000 labor hours and 1,000 machine hours are available, how many units of each
component shall be manufactured or outsourced?

Solution
A. To nd the optimum solution, we need to compare the relevant cost of making each component
with the buying price.

Charger Battery Earphone

$ $ $

Total cost 100,000 80,000 120,000

Less: Non-Relevant Costs

Depreciation 10,000 10,000 20,000 

Charger Battery Earphone

Non-manufacturing overheads 10,000 20,000 30,000

Relevant cost 80,000 50,000 70,000

Units 10,000 10,000 10,000

Relevant Cost per Unit 8 5 7

Acquisition Price 10 4 8

Incremental cost of buying 2 (1) 1

Make or Buy Make Buy Make

Units 10,000 10,000 10,000

As the internal cost of making batteries exceeds the external price of buying, it is bene cial to
outsource their production entirely. Chargers and earphones will be produced internally to
minimize cost.

B. We need to rank the three components for production priority based on the incremental cost per
limiting factor.

Batteries are excluded from the calculation of production priority because they will be outsourced
anyway based on our assessment in Part A.

Charger Earphone

Calculation of Production Priority $ $ 

Charger Earphone

Incremental saving from internal manufacturing 2 1

Labor hours per unit 0.5 0.2

Incremental saving Per unit of limiting factor 4 5

Production rank 2 1

Self-production of earphones result in higher savings per labor hour compared to chargers which
rank them higher in the production priority.

Phone Inc. should use labor hours in the production of maximum units of earphones and
manufacture chargers only if any surplus labor hours are available.

Component Hours Earphone

 Component Hours Earphone

Earphone (10,000 units × 0.2) 2,000 10,000

Charger (3000 hours – 2000) 1,000 (1000 / 0.5) 2,000

Total 3,000

Once we have calculated the self-manufactured units of each accessory, we can calculate the
number of units we need to outsource as the balancing gure.

Units Charger Battery Earphone


Make 2,000 0 10,000

Units Charger Battery Earphone

Buy 8,000 10,000 0

Total 10,000 10,000 10,000

C. We are going to solve this part of the problem by using the Simplex Method of linear
programming because it involves multiple constraints and products. If you are unfamiliar with the
basics of linear programming, I suggest you review this lesson.

To solve this problem, we rst we need to de ne the objective function and enter data relating to
the cost and constraints for each accessory in Microsoft Excel.
 

We then use the Solver function to mark the relevant data as follows:
Pressing the Solve button will return you the optimum solution:


We cannot cover all aspects of the Simplex Method in this article as the topic deserves a video
tutorial of its own which I will be adding soon.

Do subscribe to our YouTube channel to catch any updates. Let us know if you have any questions
on this topic in the comments below.

 Shutdown or continue decisions

Relevant cost and decision making 

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Table of Contents 

 Why Outsource?

 Qualitative Analysis

 Quantitative Analysis

 Example

 Solution

About the author 

Ammar Ali is an accountant and educator. He loves to cycle, sketch, and

learn new things in his spare time.
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