Make Or Buy Decision

 
Lets suppose you are a car manufacturer, and you all have the components needed to make a car except one. Now you have two options to consider:

• Either to make the component internally
• Or buy it from an outside supplier

 Making the product internally would give the management more control over the production, they can continually inspect the product for its quality. On the other hand, contracting the work to an external suppliers may mean better and efficient product, as the external supplier may possess specialist skills and the expertise in the area. 


As stated in my 'Shutdown Decision' article, that when making a decision, financial as well as non-financial aspects should be taken into consideration. The same concept applies here, when considering make or buy, don't just consider the cost savings.


What Financial aspects should consider?

From a financial perspective, first you should look at the variable saving cost per unit.e.g. the total variable cost of making product A is $17 and an external supplier has quoted a price of $15 per unit. Buying would result in a $2 cost saving per product, but if instead of $15 he quoted a price of $20, than it would increase the cost by $3. 

Moving on after variable cost, you consideration should move onto the directly attributable fixed cost, because closure of producing the component internally could result in saving the directly attributable cost (only directly attributable fixed cost can be saved not the general fixed cost).


.e.g 
        the unit variable cost of making component A is     $12
        And the variable cost of buying the product is         $14
        The directly attributable fixed cost is:                 $8,000
        Annual demand is:                                                 3,000 units
       
Although buying the component externally would increase the total variable cost by ((14-12) x 3000) $6,000. But as sub contracting the work externally would result in a $8,000 cost savings (directly attributable fixed cost) the net saving would be (8000 - 6000) $2,000.


What Non-Financial aspect should you consider?


Non-Financial decision that should be taken into consideration are:

1. Will the external supplier be reliable, in terms of quality and delivery on time?
2. Will the company lose its control over the production process, by sub contracting the work?
3. Sub contracting the work to external suppliers will result in spare capacity, how should this spare capacity be used to maximize the profits?
4. Are the cost estimates accurate, on which the decisions are based?

These are just a few points to consider, a management of a company should closely look at the financial and non-financial matters regarding the make or buy decision. 


A detailed analysis should be carried out considering all the aspects before making a sound decision.


Please leave a comment below, if you have any queries or suggestions.
Thank You