Make or buy decisions

February 12, 2015

These days companies manufacture a lot of product varieties.†Each product requires multiple parts to be created. Manufacturers can produce such parts themselves or they can buy them. Of course, the choice of producing parts or buying them includes various aspects and one of them is cost.†In this article, we will discuss make or buy decisions.

1. Make or buy decisions in theory

The essence of a make or buy decision is to manufacture a product if it costs less than to buy it; and vise versa, to buy the product if doing so will cost less.

Costs are compared for both make and buy options and the one with the lower total cost is chosen (note: there are other factors to be considered besides cost; however, for the purpose of this discussion we will assume that only the cost factor should be analyzed).

There are costs which can be changed (avoided) and costs which cannot be avoided.† The first type of costs is also called relevant costs and the second type is called irrelevant costs.

Examples of relevant costs in the context of a make or buy decision include direct labor, direct materials, variable overhead.† Other costs that should be considered in this category are any incremental costs necessary for a part manufacturing.† For example, if a company decides to make a part internally, but this requires aa purchase of additional equipment, the cost of such equipment is relevant for the decision.† In addition, sometimes making one decision or another can result in income which should be considered in the analysis; for instance, if a company decides to buy a product from a vendor and the manufacturing space frees up, it can be leased and result in income.† Such income would be part of the whole make or buy decision analysis.

Examples of irrelevant costs are sunk costs (e.g., prior fixed asset acquisitions) and fixed overhead.

In making a make or buy decision, a company would compare costs under both make and buy options by considering relevant costs.† Irrelevant costs would be ignored because they cannot be changed.

2. Example of a make or buy decision

Letís take a look at an example of a make or buy decision.† Assume that Friends Company manufactures a product which requires a particular type of valves. The company currently purchases the valves from a supplier at a price of $5 per unit.† The company can also produce the valves internally. In the coming year, the company anticipates a need for 10,000 of such valves.† If the company produces the valve internally, it will incur the following costs:

  • Direct labor = $1/unit
  • Direct material = $2/unit
  • Variable overhead = $0.5/unit

The manufacturing process for the valves would also require a purchase of tooling which is typically used within a year.† The cost of such tooling for the 10,000 valves is $20,000.

Based on this information, Friends Company performs the following analysis:

Cost Item

Per Unit Cost

Total Cost for 10,000 Units

Direct labor

$1.0

$10,000

Direct materials

$2.0

$20,000

Variable overhead

$0.5

$5,000

Annual tooling

n/a

$20,000

Total cost

 

$55,000

From the table above, it will cost $55,000 to manufacture 10,000 valves. At the same time, it only costs $50,000 to buy the valves from the supplier.† Friends Company should continue buying the valves from the supplier.

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