Make or Buy Decision Meaning
A Make or Buy Decision is a decision made to either manufacture a product/ service in house or to buy it from outside suppliers (outsourcing) on the basis of cost-benefit analysis. A make or buy decision can be made using quantitative or qualitative analysis and most of the time the results of quantitative analysis (cost-benefit analysis) are enough to decide on whether to make the product in-house or buy (outsource) from outside suppliers.
How Does Make or Buy Decision Work?
The decision is applicable to both goods and services. Businesses compare the cost and benefits of producing the goods or services within the company and the cost and benefits of getting an outside supplier to supply the goods and services into consideration. The cost here must include all the costs associated with manufacturing (including material, labor, cost of machinery and space), storing, moving, taxes, etc. and the corresponding benefits must include benefits in terms of increased margins (for in-house production) or low capital requirement (for outsourcing).
Analysis for Make or Buy Decision
Let’s discuss the analysis of make or buy decisions.
- Under quantitative analysis, businesses consider all the costs associated with producing the product or service in-house. These costs include the cost of buying and maintaining equipment, cost of the premises (lease, etc.), raw material cost, conversion cost, cost of fuel and electricity, labor cost, warehousing or storage cost, shipping cost, and the cost of capital. The benefits include higher margins from in-house production.
- The cost associated with outsourced production includes the price of the product and service, transportation, warehousing, and storage and labor costs for managing the logistics.
- The decision becomes a little straightforward if the company does not have an idle capacity to produce the product or service. In this case, the management can opt to hire an outside supplier considering that the product is not of critical importance and the firm’s intellectual property is not endangered.
- Considering the company has the idle capacity and it is already incurring a large part of fixed expenses, it can choose to manufacture in the house if the marginal cost of manufacturing is less than what it will cost to buy from outside suppliers.
Examples of Make or Buy Decision
Lest discuss examples of make or buy decisions for better understanding.
Make or Buy Decision Example #1
As stated earlier, there may be a number of factors at play that may influence a company’s company’s decision of making an item in the house or outsourcing it.
Under such circumstances two factors are to be considered:
- Whether surplus capacity is available and
- The marginal cost of per unit manufacturing
Assume a company is deciding between manufacturing a part in-house that costs $26 per unit including direct cost, fixed overheads and variable overheads as given in the table below.
The same part is available in the market at $23 per unit including the cost of buying, shipping, and warehousing as shown in the table below.
Should the Firm Make or Buy the part?
If surplus capacity available will remain idle if the component is bought, out of pocket expenses will be $23 per unit, $1 more than the variable and direct cost of making component which is $22 ($15 + $7). Hence it is economical to make it. However, if the Firm is utilizing or can utilize the capacity in making some other part which contributes to say $4 per unit in profits. The effective cost of buying the component will be $19 ($23 less $4 contribution from other products). In that case, it would be economical to buy the Component at $23 per unit from outside.
The relevant calculation for taking decision may be as follows:
Make or Buy Decision Example #2
The smartphone giant Apple Inc. outsources the manufacturing of all its devices to China because manufacturing is not its core competency and it is also significantly cheaper to assemble the devices in China due to significantly lower cost. Apple designs it produces in its office in the United States, the products are then manufactured in China and shipped back to the United States and other countries for sales.
Factors Considered for Make or Buy Decision
The following are the major factors considered while deciding to make the good or service in-house.
- Cost concerns (when it is expensive to outsource)
- Desire to enhance the manufacturing focus
- Intellectual property concerns
- Quality concerns
- Unreliable suppliers
- The need for direct quality control over the product
- Emotional reasons (for example pride)
- Absence/shortage of competent suppliers
- Insignificant volume for a prospective supplier
- Reduction of shipping and transportation costs
- For maintaining a backup source
- Environmental reasons
- Political reasons
The following are the major factors considered while deciding to buy the good or service from the outside supplier.
- Lack of expertise
- Research and specialized know-how of the supplier better than the buyer
- Cost considerations (cheaper to buy the item)
- Insufficient or no manufacturing capacity at the buyer’s end
- De-Risking the sourcing
- Low-volume requirements
- Supplier is more equipped than the buyer
- Procurement and inventory considerations
- Product or service not essential to the firm’s strategy
- Preference of Brand
Advantages of Make or Buy Decision
Some of the advantages of make or buy decisions are as follows:
- The decision helps choose the most efficient option to go about in-house production of outsourcing.
- The decision helps in the strategic maneuver of the business.
- The decision helps save the cost for many businesses.
- Businesses benefit from the lower cost of mistakes if they think strategically about this decision.
The make or buy decision should be taken with utmost care keeping the long term as well as short term benefits into consideration. There are pros and cons to both make and buy, however, generally businesses tend to outsource function where they do not have a core competency or when the cost of procuring the components or services from outside suppliers is significantly cheaper.
This has been a guide to what is make or buy decision and its meaning. Here we discuss how does make or buy decision works along with its factors and examples. You can more about finance from the following articles –