A bottling company in Ibadan makes its own crates. The works manager says they cost ₦180 each in the books, the crate maker down the road quotes ₦150, and the accountant is asked whether to stop making them. The books’ ₦180 includes rent and supervision that continue whatever is decided, and machines that could be sold, and a labour force that is short of hours for the main product.
The right answer depends on which of those costs actually change. This topic explains how to decide whether to make or buy, using relevant costs; how to decide what to buy when a scarce resource limits what can be made; how to compare options over several years with discounting; the advantages and disadvantages of outsourcing; and the non-financial factors that often decide the matter.
It builds on the earlier topic on market-based pricing. The next topic covers one-off contracts, shutdown and further processing decisions.
In 30 seconds
A make-or-buy decision compares the relevant cost of making with the price of buying. Relevant costs are future cash flows that differ between the options: variable costs of making, avoidable fixed costs and the opportunity cost of resources used. Ignore unavoidable fixed costs, absorbed overhead that continues anyway, and sunk costs.
If making uses a scarce resource, compare the extra cost of buying per unit of the scarce resource and buy first the item with the lowest figure. If the choice lasts several years, compare the present values, including the sale of equipment and savings in rent. The maximum price to pay is the relevant cost of making (the indifference price).
Outsourcing lets the company focus on core activities, may cut cost and capital spending, but risks loss of control, skills and confidentiality, dependence on a supplier and staff resistance. Non-financial factors include quality, reliability of delivery, labour relations and strategic control. Full marks come from the relevant cost schedule, the decision and a balanced view of the other factors.
Deciding to make or buy
What is relevant
Only costs that change with the decision are relevant.
- Variable costs of making (materials, labour that can be avoided, variable overhead) are saved if the company buys, so they are relevant.
- Avoidable fixed costs such as a supervisor who would be dismissed or a rent that would end are relevant.
- Unavoidable fixed costs that continue in both cases, and absorbed overhead that is only an allocation, are not relevant.
- Opportunity costs. If making uses a machine or space that could earn money elsewhere (sold, hired out or used for another product), that income is a cost of making.
- Cash from disposals. The proceeds of selling equipment that would not be needed are a benefit of buying.
- Sunk costs and depreciation are not relevant.
The decision rule: make if the relevant cost of making is below the price of buying; buy if it is above. The indifference price is the price at which the two are equal, and it is the most the company should agree to pay a supplier.
When a resource is scarce
If the company cannot make everything it needs because of a shortage of labour hours, machine time or materials, it must decide which items to buy. The aim is to give up as little as possible for each unit of the scarce resource saved.
For each item, calculate the extra variable cost of buying (price − variable cost of making), and divide by the amount of scarce resource used in making one unit. Buy first the item with the lowest extra cost per unit of the scarce resource. Continue until the shortage is covered.
Over several years
If the decision commits the company for several years, compare the present values of the relevant cash flows at the cost of capital. Include the one-off items at the start (such as the sale of a machine), the annual costs and savings, and any costs that occur only in some years. Ignore depreciation, which is not a cash flow.
Outsourcing and the non-financial factors
Outsourcing is the use of an outside supplier for an activity or product that the company could do itself. A make-or-buy decision for a component is a simple form; outsourcing may cover whole functions such as payroll, transport or information technology.
Advantages
- The company can focus on its core competences, which may improve quality and efficiency.
- A specialist supplier may do the work at lower cost or better quality, because it has scale and skills.
- Capital spending falls, since plant and equipment are not needed, and under-used assets are avoided, which improves measures such as return on assets and asset turnover.
- It can improve service to customers, which helps retention and repeat sales.
- It makes costs more variable and the business more flexible.
Disadvantages
- Staff resistance. Employees fear job losses.
- Loss of critical skills over time, which are expensive to rebuild, and dependence on a supplier who may raise prices once the skills are gone.
- Quality and reliability depend on the supplier, and failure by the supplier harms the company’s own reputation.
- Loss of confidential data: a competitor may gain access, or analyse the product more easily.
- Loss of managerial control, and late delivery.
- The supplier may turn to a competitor, and choosing a supplier takes time and effort.
- The supposed saving may not appear, because of the cost of managing the contract.
Non-financial factors that may favour making
- Quality control and the need to protect product quality.
- Delivery and continuity of supply, especially when the part is needed for years and strategic control matters.
- Labour relations if the staff doing the work would be laid off.
- Confidentiality and protection of know-how.
- Flexibility to change the design or volume quickly.
Factors that may favour buying include the supplier’s specialist skills, the release of management time and capital, and the avoidance of the risk of owning plant that may become obsolete.
Layouts for make-or-buy decisions
- Relevant cost of making. Variable costs + avoidable fixed costs + opportunity costs. Leave out absorbed or unavoidable overhead.
- Cost of buying. Price × units, less any savings (such as rent), less any proceeds of disposal.
- Decision. Lower relevant cost wins. The difference is the saving.
- Scarce resource. For each item: (buy price − variable cost of making) ÷ units of scarce resource per unit. Buy the lowest first.
- Several years. Present value of each cash flow, using the annuity factor for regular amounts.
- Indifference price. The price at which the present values (or costs) are equal.
Money is in naira and each answer is rounded once, at the end.
Worked examples
Example 1: a simple decision, then with an opportunity. A company makes 5,000 units of a part. Variable costs are ₦50 material, ₦40 labour and ₦15 variable overhead a unit. Specific fixed costs of ₦10,000 a year would be saved if it stopped making the part. A fixed overhead absorption of ₦20 a unit continues anyway. A supplier offers the part at ₦125. Required: the decision, and the effect if the freed capacity could earn a contribution of ₦100,000.
- Relevant cost of making.
(50 + 40 + 15) × 5,000 = 525,000
plus avoidable fixed 10,000 = ₦535,000.
The absorbed ₦20 is ignored. - Cost of buying.
125 × 5,000 = ₦625,000. - Decision. Make.
The saving is 625,000 − 535,000 = ₦90,000. - With the opportunity.
If the capacity freed by buying could earn ₦100,000, the cost of buying is 625,000 − 100,000 = ₦525,000, below ₦535,000.
The decision reverses: buy, gaining ₦10,000.
Example 2: a scarce resource. A company needs 3,000 units of part X and 2,000 units of part Y. Making X costs ₦60 in variable cost and uses 2 labour hours; buying costs ₦80. Making Y costs ₦80 and uses 5 hours; buying costs ₦120. Only 15,000 labour hours are available. Required: what to buy.
- Hours needed.
X 3,000 × 2 = 6,000; Y 2,000 × 5 = 10,000; total 16,000.
Shortage 1,000 hours. - Extra cost of buying per hour saved.
X (80 − 60) ÷ 2 = ₦10.
Y (120 − 80) ÷ 5 = ₦8. - Buy the lowest first. Buy Y.
1,000 hours ÷ 5 = 200 units of Y. - Extra cost.
200 × 40 = ₦8,000.
Buying X instead would cost 500 units × 20 = ₦10,000.
Example 3: over four years. A company makes 2,000 units a year of a part, with variable costs of ₦110 a unit and avoidable fixed engineering costs of ₦20,000 a year. A supplier would charge ₦150 a unit for four years. Buying would save rent of ₦6,000 a year and the equipment could be sold now for ₦40,000. The cost of capital is 12% (annuity factor for four years: 3.0373). Required: the decision and the indifference price.
- Make.
Annual cost 110 × 2,000 + 20,000 = 240,000.
Present value 240,000 × 3.0373 = ₦728,952. - Buy.
Annual cost 150 × 2,000 = 300,000, less rent saved 6,000 = 294,000.
Present value 294,000 × 3.0373 = 892,966
less sale proceeds 40,000 = ₦852,966. - Decision. Make. Buying costs ₦124,014 more in present value terms.
- Indifference price.
Let the price be P: 2,000P × 3.0373 − 6,000 × 3.0373 − 40,000 = 728,952, so 6,074.6P = 728,952 + 18,224 + 40,000, P = ₦129.58.
The company should buy only if the supplier charges less than that.
Expect variants: several parts competing for one scarce resource, a discount offered for large orders, or a question asking only for the non-financial factors.
Common mistakes
- Using full absorption cost. Include only costs that change.
- Missing the opportunity cost of capacity or equipment.
- Ranking by total extra cost when a resource is scarce. Rank by extra cost per unit of the resource.
- Including depreciation in a multi-year comparison.
- Forgetting to discount. Use present values over several years.
- Ignoring non-financial factors. Mention quality, delivery, labour and control.
Quick revision
- Make if relevant cost of making is below the price; relevant = variable + avoidable fixed + opportunity cost.
- Scarce resource: buy the item with the lowest extra cost per unit of the resource.
- Several years: present values; include disposal proceeds and savings; indifference price.
- Outsourcing: focus, specialist cost and capital saving; versus control, skills, quality and confidentiality.
How the marks are earned
- Schedule: each relevant item with a reason, and the irrelevant items excluded.
- Decision: the comparison and the saving or the indifference price.
- Discussion: two or more non-financial factors, applied to the case.
Practice questions
These are original questions, written in the style of the Skills examination. Work each one before you open the answer.
Recall check: multiple choice
Question 1. In a make-or-buy decision the relevant costs of making are:
- All absorbed costs
- Depreciation
- Avoidable costs and opportunity costs
- Sunk costs
Show the answer
C. Only costs that change matter.
Question 2. Unavoidable fixed overhead that continues in both cases is:
- Relevant
- Irrelevant
- An opportunity cost
- A saving
Show the answer
B. It does not differ between the options.
Question 3. With a scarce resource, buy first the item with:
- The lowest extra cost per unit of the scarce resource
- The highest price
- The highest volume
- The lowest variable cost
Show the answer
A. This gives up the least for each unit saved.
Question 4. A disadvantage of outsourcing is:
- Lower capital spending
- Better focus
- Specialist skills
- Loss of control and of critical skills
Show the answer
D. Confidentiality may also be lost.
Question 5. An advantage of outsourcing is that the company can:
- Focus on its core competences
- Avoid all risk
- Ignore quality
- Increase capital spending
Show the answer
A. A specialist may also cost less.
Question 6. If capacity freed by buying could earn contribution elsewhere, that contribution is:
- Irrelevant
- A sunk cost
- An opportunity cost of making
- A fixed cost
Show the answer
C. It reduces the cost of buying.
Question 7. Over several years the options should be compared using:
- Book values
- Present values of relevant cash flows
- Depreciation
- Absorbed overhead
Show the answer
B. Time value of money matters.
Question 8. Which is a non-financial factor in a make-or-buy decision?
- Absorbed overhead
- Depreciation
- Interest
- Reliability of supply and quality
Show the answer
D. Labour relations are another.
Question 9. The proceeds of selling equipment that is no longer needed if the company buys are:
- Ignored
- A fixed cost
- A relevant benefit of buying
- Depreciation
Show the answer
C. They are a future cash inflow.
Question 10. The indifference price is the price at which:
- The cost of making equals the cost of buying
- Profit is highest
- Demand is zero
- The supplier loses money
Show the answer
A. It is the most to pay a supplier.
Section B style: written questions
Question 11 (10 marks). (a) State THREE advantages and THREE disadvantages of outsourcing. (6 marks) (b) State FOUR non-financial factors that favour making a part in-house. (4 marks)
Question 12 (15 marks). A company makes 5,000 units of a part. Variable costs are material ₦50, labour ₦40 and variable overhead ₦15 a unit. Specific fixed costs of ₦10,000 would be saved if it stopped making the part. Fixed overhead of ₦20 a unit is absorbed but continues in any case. A supplier offers the part at ₦125.
(a) Calculate the relevant cost of making. (4 marks) (b) Calculate the cost of buying. (2 marks) (c) State the decision and the saving. (3 marks) (d) State FOUR non-financial factors. (4 marks) (e) Show the effect if buying would free capacity that could earn ₦100,000. (2 marks)
Question 13 (20 marks). A company makes 2,000 units a year of a part for four years. Variable costs are ₦110 a unit and avoidable fixed costs ₦20,000 a year. A supplier offers ₦150 a unit. Buying would save rent of ₦6,000 a year and the equipment could be sold now for ₦40,000. The cost of capital is 12% (annuity factor for four years: 3.0373).
(a) Calculate the present value of the cost of making. (6 marks) (b) Calculate the present value of the cost of buying. (6 marks) (c) State the decision and calculate the indifference price. (4 marks) (d) Discuss TWO non-financial factors. (4 marks)
Model answers
Show the model answer to Question 11
(a) Advantages, any three: focus on core competences; possibly lower cost; less capital spending; better service to customers; more flexible cost structure. Disadvantages, any three: staff resistance; loss of critical skills; dependence on the supplier’s quality and delivery; loss of confidential data; loss of control; reputation risk (1 each).
(b) Any four: quality control; continuity and reliability of supply; labour relations; confidentiality; flexibility to change design or volume; strategic control (1 each).
Show the model answer to Question 12
(a)
- Variable (50 + 40 + 15) × 5,000 = 525,000
- plus avoidable fixed 10,000 = ₦535,000.
- The absorbed ₦20 continues in any case and is ignored (4).
(b) 125 × 5,000 = ₦625,000 (2).
(c) Make; the saving is ₦90,000 (3).
(d) Any four: quality; reliability of delivery; labour relations; confidentiality; control; flexibility (1 each).
(e) The cost of buying becomes 625,000 − 100,000 = ₦525,000, below the cost of making, so the decision reverses and buying gains ₦10,000 (2).
Show the model answer to Question 13
(a)
- Annual cost of making 110 × 2,000 + 20,000 = 240,000
- × 3.0373 = ₦728,952 (6).
(b)
- Annual cost of buying 150 × 2,000 = 300,000, less rent 6,000 = 294,000
- × 3.0373 = 892,966
- less 40,000 = ₦852,966 (6).
(c)
- Make; buying costs ₦124,014 more.
- Indifference price.
6,074.6P = 728,952 + 18,224 + 40,000, so P = ₦129.58 (4).
(d) Any two, applied:
- quality of the part
- reliability and continuity of supply over four years
- the reaction of the staff who would lose their jobs
- loss of skills and control (2 each)
Pathfinder on Make or buy and outsourcing decisions
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Limiting factor with special order and penalty; outsourcing pros and cons; budget constraint causes.
Revise first: Layouts for make-or-buy decisions
Make or buy with discounting, indifference price, non-financial factors.
Revise first: Layouts for make-or-buy decisions
Source: ICAN Pathfinder, Performance Management. Diets covered: March/July Diet, 2020 to May Diet, 2026. All 13 diets in the Pathfinder are mapped.
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