What Is a Make-or-Buy Decision?

A make-or-buy decision is an act of choosing between manufacturing a product

in-house or purchasing it from an external supplier.

Also referred to as an outsourcing decision, a make-or-buy decision compares

the costs and benefits associated with producing a necessary good or service
internally to the costs and benefits involved in hiring an outside supplier for the
resources in question. To compare costs accurately, a company must
consider all aspects regarding the acquisition and storage of the items versus
creating the items in-house.

KEY TAKEAWAYS

 A make-or-buy decision is an act of choosing between manufacturing a

product in-house or purchasing it from an external supplier.
 Make-or-buy decisions, like outsourcing decisions, speak to a comparison
of the costs and advantages of producing in-house versus buying it
elsewhere.
 There are many factors at play that may tilt a company from making an
item in-house or outsourcing it.
Understanding Make-or-Buy Decisions
Regarding in-house production, a business must include expenses related to the
purchase and maintenance of any production equipment and the cost of
production materials. Make costs can include the additional labor required to
produce the items, storage requirements within the facility, storage costs overall,
and the proper disposal of any remnants or byproducts from the production
process.

Buy costs related to purchasing the products from an outside source must
include the price of the good itself, any shipping or importing fees, and
applicable sales tax charges. Additionally, the company must factor in the
expenses relating to the storage of the incoming product and labor costs
associated with receiving the products into inventory.

 
In a make-or-buy decision, the most important factors to consider are part of
quantitative analysis, such as the associated costs of production and whether the
business can produce at required levels.

Special Considerations
The results of the quantitative analysis may be sufficient to make a determination
based on the approach that is more cost-effective. At times, the qualitative
analysis addresses any concerns a company cannot measure specifically.

Factors that may influence a firm's decision to buy a part rather than produce it
internally include a lack of in-house expertise, small volume requirements, a
desire for multiple sourcing, and the fact that the item may not be critical to the
firm's strategy. A company may give additional consideration if the firm has the
opportunity to work with a company that has previously provided outsourced
services successfully and can sustain a long-term relationship.

If a firm is going to buy or outsource, it's essential that they work with a company
that they can rely on for the long-term.
Similarly, factors that may tilt a firm toward making an item in-house include
existing idle production capacity, better quality control or proprietary technology
that needs to be protected. A company may also consider concerns regarding
the reliability of the supplier, especially if the product in question is critical to
normal business operations. The firm should also consider whether the supplier
can offer the desired long-term arrangement.

Make–or–Buy Decisions

The make-or-buy decision is the act of making a strategic

choice between producing an item internally (in-house) or
buying it externally (from an outside supplier). The buy side of
the decision also is referred to as outsourcing. Make-or-buy
decisions usually arise when a firm that has developed a
product or part—or significantly modified a product or part—is
having trouble with current suppliers, or has diminishing
capacity or changing demand.
Make-or-buy analysis is conducted at the strategic and
operational level. The strategic level is the more long-range of
the two. Variables considered at the strategic level include
analysis of the future, as well as the current environment.
 Issues like government regulation, competing firms, and market
trends all have a strategic impact on the make-or-buy decision.
Of course, firms should make items that reinforce or are in-line
with their core competencies. These are areas in which the firm
is strongest and which give the firm a competitive advantage.
The increased existence of firms that utilize the concept of lean
manufacturing has prompted an increase in outsourcing.
Manufacturers are tending to purchase sub-assemblies rather
than piece parts, and are outsourcing activities ranging from
logistics to administrative services.
In their 2003 book World Class Supply Management, David
Burt, Donald Dobler, and Stephen Starling present a rule of
thumb for outsourcing. It prescribes that a firm
outsource all items that do not fit one of the following three
categories: (1) the item is critical to the success of the product,
including customer perception of important product attributes;
(2) the item requires specialized design and manufacturing
skills or equipment and the number of capable and reliable
suppliers is extremely limited; and (3) the item fits well within
the firm's core competencies, or within those the firm must
develop to fulfill future plans. Items that fit under one of these
three categories are considered strategic in nature and should
be produced internally if at all possible.
Make-or-buy decisions also occur at the operational level.
Analysis in separate texts by Burt, Dobler, and Starling, as well
as Joel Wisner, G. Keong Leong, and Keah-Choon Tan,
suggest these considerations that favor making a part in-house:

 Cost considerations (less expensive to make the part)

 Desire to integrate plant operations
 Productive use of excess plant capacity to help absorb
fixed overhead (using existing idle capacity)
 Need to exert direct control over production and/or quality
 Better quality control
 Design secrecy is required to protect proprietary
technology
 Unreliable suppliers
 No competent suppliers
 Desire to maintain a stable workforce (in periods of
declining sales)
 Quantity too small to interest a supplier
 Control of lead time, transportation, and warehousing costs
 Greater assurance of continual supply
 Provision of a second source
 Political, social, or environmental reasons (union pressure)
 Emotion (e.g., pride)

Factors that may influence firms to buy a part externally include:

 Lack of expertise
 Suppliers' research and specialized know-how exceeds
that of the buyer
 Cost considerations (less expensive to buy the item)
 Small-volume requirements
 Limited production facilities or insufficient capacity
 Desire to maintain a multiple-source policy
 Indirect managerial control considerations
 Procurement and inventory considerations
 Brand preference
 Item not essential to the firm's strategy

The two most important factors to consider in a make-or-buy

decision are cost and the availability of production capacity.
 Burt, Dobler, and Starling warn that “no other factor is subject to
more varied interpretation and to greater misunderstanding.”

Cost considerations should include all relevant costs and be

long-term in nature. Obviously, the buying firm will compare
production and purchase costs. Burt, Dobler, and Starling
provide the major elements included in this comparison.
Elements of the “make” analysis include:

 Incremental inventory-carrying costs

 Direct labor costs
 Incremental factory overhead costs
 Delivered purchased material costs
 Incremental managerial costs
 Any follow-on costs stemming from quality and related
problems
 Incremental purchasing costs
 Incremental capital costs

Cost considerations for the “buy” analysis include:

 Purchase price of the part

 Transportation costs
 Receiving and inspection costs
 Incremental purchasing costs
 Any follow-on costs related to quality or service

It should be noted that six of the costs to consider are

incremental. By definition, incremental costs would not be
incurred if the part were purchased from an outside source.
If a firm does not currently have the capacity to make the part,
incremental costs will include variable costs plus the full portion
of fixed overhead allocable to the part's manufacture. If the firm
has excess capacity that can be used to produce the part in
question, only the variable overhead caused by production of
the parts are considered incremental. That is, fixed costs, under
conditions of sufficient idle capacity, are not incremental and
should not be considered as part of the cost to make the part.
While cost is seldom the only criterion used in a make-or-buy
decision, simple break-even analysis can be an
effective way to quickly surmise the cost implications within a
decision. Suppose that a firm can purchase equipment for in-
house use for $250,000 and produce the needed parts for $10
each. Alternatively, a supplier could produce and ship the part
for $15 each. Ignoring the cost of negotiating a contract with the
supplier, the simple break-even point could easily be computed:
$250,000 + $10Q = $15Q

$250,000 = $15Q  – $10Q

$250,000 = $5Q
50,000 = Q
Therefore, it would be more cost effective for a firm to buy the
part if demand is less than 50,000 units, and make the part if
demand exceeds 50,000 units. However, if the firm had enough
idle capacity to produce the parts, the fixed cost of $250,000
would not be incurred (meaning it is not an incremental cost),
making the prospect of making the part too cost efficient to
ignore.
Stanley Gardiner and John Blackstone's 1991 paper in
the International Journal of Purchasing and Materials
Management presented the contribution-per-constraint-minute
(CPCM) method of make-or-buy analysis, which makes the
decision based on the theory of constraints. They also used this
approach to determine the maximum permissible component
price (MPCP) that a buyer should pay when outsourcing. In
2005 Jaydeep Balakrishnan and Chun Hung Cheng noted that
Gardiner and Blackstone's method did not guarantee a best
solution for a complicated make-or-buy problem. Therefore,
they offered an updated, enhanced approach using
spreadsheets with built-in liner programming (LP) capability to
provide “what if” analyses to encourage efforts toward finding
an optimal solution.
Firms have started to realize the importance of the make-or-buy
decision to overall manufacturing strategy and the implication it
can have for employment levels, asset levels, and core
competencies. In response to this, some firms have adopted
total cost of ownership (TCO) procedures for incorporating non-
price considerations into the make-or-buy decision.
SEE ALSO Break-Even Point

BIBLIOGRAPHY
Balakrishnan, Jaydeep, and Chun Hung Cheng. “The Theory of
Constraints and the Make-or-Buy Decision: An Update and
Review.” Journal of Supply Chain Management: A Global
Review of Purchasing & Supply 41, no. 1 (2005): 40–47.
Encyclopedia 1080

00:00 of 01:04Volume 0%
 
Burt, David N., Donald W. Dobler, and Stephen L.
Starling. World Class Supply Management: The Key to Supply
Chain Management. 7th ed. Boston: McGraw-Hill/Irwin, 2003.

Gardiner, Stanley C., and John H. Blackstone, Jr. “The ‘Theory

of Constraints’ and the Make-or-Buy Decision.” International
Journal of Purchasing & Materials Management 27, no. 3
(1991): 38–43.

Moschuris, Socrates J. “Triggering mechanisms in make-or-buy

decisions: an empirical analysis.” Journal of Supply Chain
Management: A Global Review of Purchasing & Supply. 43, no.
1 (2007): 40–50.

Parmigiani, Anne E. “Why Do Firms Both Make and Buy? An

Investigation of Concurrent Sourcing.” Strategic Management
Journal. 28 (2007): 285–311.

Wisner, Joel D., G. Keong Leong, and Keah-Choon

Tan.Principles of Supply Chain Management: A Balanced
Approach. Mason, OH: Thomson South-Western, 2005.
Encyclopedia of Management

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ABOUT THIS ARTICLE

Make–or–Buy Decisions
Updated Sep 11 2020About encyclopedia.com contentPrint Article
Manufacturing businesses have to consider cost-lowering decisions on a daily basis. This article
will take you through all the basic things you need to know with respect to the vital cost-saving
decision known as make-or-buy. You’ll learn 1) what is make-or-buy decision? 2) factors
influencing the decision, 3) how to arrive at a make-or-buy decision, and an 4) example.
WHAT IS MAKE-OR-
BUY DECISION?
The make-or-buy decision is the action of deciding between manufacturing an item
internally (or in-house) or buying it from an external supplier (also known as
outsourcing). Such decisions are typically taken when a firm that has manufactured a
part or product, or else considerably modified it, is having issues with current suppliers,
or has reducing capacity or varying demand.

Another way to define make-or-buy decision that is closely related to the first definition
is this: a decision to perform one of the activities in the value chain in-house, instead of
purchasing externally from a supplier. A value chain is the complete range of tasks –
such as design, manufacture, marketing and distribution of a product / service that
businesses must get done to take a service or product from conception to their
customers.

Some companies manage all of the tasks in the value chain from manufacturing raw
materials all through to the ultimate distribution of the completed goods and provision of
after-sales services. Some other companies are happy just to integrate on a smaller
scale by buying a lot of the parts and materials that are required for their finished
products. When a business is involved in more than one activity in the whole value
chain, it is vertically integrated. This kind of integration is quite common.

Vertical integration provides its own set of advantages. An integrated company depends
less on its suppliers and so can be certain of a smoother flow of materials and parts for
the manufacture than a non-integrated company. In addition, some companies believe
they can manage quality better by manufacturing their own parts and materials instead
of depending on the quality control standards of external suppliers. What’s more, an
integrated company realizes revenue from the parts and material that it is “making”
rather than “buying” in addition to income from its usual operations.

The benefits of vertical integration are counterbalanced by the benefits of using outside
suppliers. By combining demand from different companie, a supplier can enjoy econoies
of scale. These economies of scale can cause better quality and lower expenses than
would be possible if the business were to endeavor to manufacture the parts or provide
a service by itself. At the same time, a business should be careful to retain control over
those tasks that are necessary for maintaining its competitive position. Case in point:
Hewlett Packard manages the software for laser printers that it manufactures in
collaboration with Canon Inc. of Japan.

In the book “World Class Supply Management” published in 2003, Donald Dobler,
Stephen Starling and David Burt provide a rule of thumb for outsourcing. The rule
recommends that companies outsource all goods that do not fall into one of the
following three classes: 1) the good is critical to the product’s success including
customer discernment of key product attributes 2) the good falls well within the firm’s
key competencies, or within those the company should develop to accomplish future
plans, or 3) the item calls for specialized design and manufacturing equipment or skills.

FACTORS
INFLUENCING THE
DECISION
To come to a make-or-buy decision, it is essential to thoroughly analyze, all of the
expenses associated with product development in addition to expenses associated with
buying the product. The assessment should include qualitative and quantitative factors.
It should also separate relevant expenses from irrelevant ones and consider only the
former. The study should also look at the availability of the product and its quality under
each of the two situations.

Introduction to quantitative and

qualitative analysis
Quantitative aspects can be calculated and compared whereas qualitative aspects call
for subjective judgment and, frequently require multiple opinions. In addition, some of
the associated factors can be quantified with sureness while it is necessary to estimate
other factors. The make-or-buy decision calls for a thorough assessment from all
angles.

Quantitative aspects are essentially the incremental costs stemming from making or
purchasing the component. Factors of this type to look at may incorporate things such
as availability of manufacturing facilities, needed resources and manufacturing capacity.
This may also incorporate variable and fixed expenses that can be found out either by
way of estimation or with certainty. Similarly, quantitative expenses would incorporate
the cost of the good under consideration as the price is determined by suppliers offering
the product for sale in the marketplace.

Qualitative factors to look at call for more subjective assessment. Examples of such
factors include control over component quality, the reliability and reputation of the
 suppliers, the possibility of modifying the decision in the future, the long-term viewpoint
concerning manufacture or purchase of the product, and the impact of the decision on
customers and suppliers.

Introduction to relevant and irrelevant

expenses
As mentioned earlier, distinguishing between these two kinds of expenses is necessary
to come to a make-or-buy decision. Relevant costs for manufacturing the good are all
the expenses that could be avoided by not manufacturing the product in addition to
the opportunity cost resulting from utilizing production facilities to manufacture the good
as against the next best alternative utilization of the manufacturing facilities. Relevant
costs for buying the product are all the expenses relating to purchasing a product from
suppliers. Irrelevant costs are the expenses involved irrespective of whether the good is
produced internally or bought externally.

Factors favoring in-house manufacture

 Wish to integrate plant operations

 Need for direct control over manufacturing and/or quality

 Cost considerations (costs less to make the part)

 Improved quality control

 No competent suppliers and/or unreliable suppliers

 Quantity too little to interest a supplier

 Design secrecy is necessary to protect proprietary technology

 Control of transportation, lead time, and warehousing expenses

 Political, environmental, or social reasons

 Productive utilization of excess plant capacity to assist with absorbing fixed overhead
(utilizing existing idle capacity)

 Wish to keep up a stable workforce (in times when there are declining sales)

 Greater guarantee of continual supply

 Factors favoring purchase from outside
 Suppliers’ specialized know-how and research are more than that of the buyer

 Lack of expertise

 Small-volume needs

 Cost aspects (costs less to purchase the item)

 Wish to sustain a multiple source policy

 Item not necessary to the firm’s strategy

 Limited facilities for a manufacture or inadequate capacity

 Brand preference

 Inventory and procurement considerations

Costs for the make analysis

 Direct labor expenses

 Incremental inventory-carrying expenses

 Incremental capital expenses

 Incremental purchasing expenses

 Incremental factory operating expenses

 Incremental managerial expenses

 Delivered purchased material expenses

 Any follow-on expenses resulting from quality and associated problems

Cost factors for the buy analysis

 Transportation expenses

 Purchase price of the part

 Incremental purchasing expenses

 Receiving and inspection expenses

 Any follow-on expenses associated with service or quality

Though the cost is rarely the sole criterion utilized to come to a make-or-buy decision,
easy break-even analysis can be a useful way to quickly guess the expense
implications within a decision.

HOW TO ARRIVE AT
A MAKE OR BUY
DECISION?
Here’s one example of a process of how businesses can make a sensible make-or-buy
decision. Businesses should first carry out an assessment of quantitative aspects before
considering qualitative aspects to finalize their make or buy decisions.

Step 1
Carry out the quantitative analysis by comparing the expenses incurred in each
option. The expense of purchasing products is the price paid to suppliers to purchase
them. On the contrary, the cost of manufacture includes both variable and fixed
expenses. For example, a business requires 10 units of its item in 10 consecutive
periods. The company can either buy the units at $100 per unit or expend $1,000 to set
up manufacture facilities and $8 to manufacture each unit. As the business expends
$10,000 to buy the products and $9,000 to manufacture the same quantity of products,
with respect to make-or-buy, the business would do better to manufacture the goods, on
the basis of only quantitative factors.

Step 2
Think about all the qualitative factors that may have a bearing on the decision to
manufacture the products. This incorporates all pertinent factors that cannot be
decreased to numbers such as the quality of the business’ production department and
its experience. An example for this is that it may be possible that the business has zero
experience in manufacturing a specific good and its previous experience in
manufacturing other goods cannot be applied.
Step 3
Think about qualitative factors that may have a bearing on the decision to buy the
products from external suppliers. Such factors include: the quality of the suppliers’
management, its dependability and the quality of its goods. An example for this is that it
is probable that the supplier has considerable experience in manufacturing the item
being considered and the business may want to develop a long-term relationship with a
supplier.

Step 4
Factor the qualitative aspects into the quantitative assessment so as to complete it.
An example for this in this case is that: even though it is cheaper for the business to
manufacture its products, there are grounds to believe that its goods would be of a
lower grade than those it can buy. In addition, as the business desires to forge a long-
term relationship with its supplier, it may desire to purchase its goods from that supplier
so as to commence the relationship.

Step 5
Arrive at a final make-or-buy decision after considering both quantitative and
qualitative factors. This would depend on the particular business and what it is doing so
as to create profits. Continuing with the above example, even if it is likely that the
business may buy better grade products than those it can manufacture in-house, the
quality of its goods/products may not have a bearing on its sales on the basis of its
business model and what it is putting on the market. If such is the case, the wish to
develop a long-term relationship may or may not be adequate to prevail over the $1,000
savings in expenses; instead it depends on how strong is the business’ yearning for the
relationship and what it hopes to accomplish by starting it.

Introduction to relevant and irrelevant

expenses
As mentioned earlier, distinguishing between these two kinds of expenses is necessary
to come to a make-or-buy decision. Relevant costs for manufacturing the good are all
the expenses that could be avoided by not manufacturing the product in addition to
the opportunity cost resulting from utilizing production facilities to manufacture the good
as against the next best alternative utilization of the manufacturing facilities. Relevant
costs for buying the product are all the expenses relating to purchasing a product from
suppliers. Irrelevant costs are the expenses involved irrespective of whether the good is
produced internally or bought externally.
 Factors favoring in-house manufacture
 Wish to integrate plant operations

 Need for direct control over manufacturing and/or quality

 Cost considerations (costs less to make the part)

 Improved quality control

 No competent suppliers and/or unreliable suppliers

 Quantity too little to interest a supplier

 Design secrecy is necessary to protect proprietary technology

 Control of transportation, lead time, and warehousing expenses

 Political, environmental, or social reasons

 Productive utilization of excess plant capacity to assist with absorbing fixed overhead
(utilizing existing idle capacity)

 Wish to keep up a stable workforce (in times when there are declining sales)

 Greater guarantee of continual supply

Factors favoring purchase from outside

 Suppliers’ specialized know-how and research are more than that of the buyer

 Lack of expertise

 Small-volume needs

 Cost aspects (costs less to purchase the item)

 Wish to sustain a multiple source policy

 Item not necessary to the firm’s strategy

 Limited facilities for a manufacture or inadequate capacity

 Brand preference

 Inventory and procurement considerations
 Costs for the make analysis
 Direct labor expenses

 Incremental inventory-carrying expenses

 Incremental capital expenses

 Incremental purchasing expenses

 Incremental factory operating expenses

 Incremental managerial expenses

 Delivered purchased material expenses

 Any follow-on expenses resulting from quality and associated problems

Cost factors for the buy analysis

 Transportation expenses

 Purchase price of the part

 Incremental purchasing expenses

 Receiving and inspection expenses

 Any follow-on expenses associated with service or quality

Though the cost is rarely the sole criterion utilized to come to a make-or-buy decision,
easy break-even analysis can be a useful way to quickly guess the expense
implications within a decision.
HOW TO ARRIVE AT
A MAKE OR BUY
DECISION?
Here’s one example of a process of how businesses can make a sensible make-or-buy
decision. Businesses should first carry out an assessment of quantitative aspects before
considering qualitative aspects to finalize their make or buy decisions.

Step 1
Carry out the quantitative analysis by comparing the expenses incurred in each
option. The expense of purchasing products is the price paid to suppliers to purchase
them. On the contrary, the cost of manufacture includes both variable and fixed
expenses. For example, a business requires 10 units of its item in 10 consecutive
periods. The company can either buy the units at $100 per unit or expend $1,000 to set
up manufacture facilities and $8 to manufacture each unit. As the business expends
$10,000 to buy the products and $9,000 to manufacture the same quantity of products,
with respect to make-or-buy, the business would do better to manufacture the goods, on
the basis of only quantitative factors.

Step 2
Think about all the qualitative factors that may have a bearing on the decision to
manufacture the products. This incorporates all pertinent factors that cannot be
decreased to numbers such as the quality of the business’ production department and
its experience. An example for this is that it may be possible that the business has zero
experience in manufacturing a specific good and its previous experience in
manufacturing other goods cannot be applied.

Step 3
Think about qualitative factors that may have a bearing on the decision to buy the
products from external suppliers. Such factors include: the quality of the suppliers’
management, its dependability and the quality of its goods. An example for this is that it
is probable that the supplier has considerable experience in manufacturing the item
being considered and the business may want to develop a long-term relationship with a
supplier.

Step 4
Factor the qualitative aspects into the quantitative assessment so as to complete it.
An example for this in this case is that: even though it is cheaper for the business to
manufacture its products, there are grounds to believe that its goods would be of a
lower grade than those it can buy. In addition, as the business desires to forge a long-
term relationship with its supplier, it may desire to purchase its goods from that supplier
so as to commence the relationship.

Step 5
Arrive at a final make-or-buy decision after considering both quantitative and
qualitative factors. This would depend on the particular business and what it is doing so
as to create profits. Continuing with the above example, even if it is likely that the
business may buy better grade products than those it can manufacture in-house, the
quality of its goods/products may not have a bearing on its sales on the basis of its
business model and what it is putting on the market. If such is the case, the wish to
develop a long-term relationship may or may not be adequate to prevail over the $1,000
savings in expenses; instead it depends on how strong is the business’ yearning for the
relationship and what it hopes to accomplish by starting it.

Outside $19 x 8000 = $152,000

purchase
expense

The difference of $40,000 supports continuing to make 8000 units.

Keep in mind that depreciation of special equipment is mentioned as one of the

expenses for manufacturing the bearings internally. Owing to the fact that the
equipment has already been bought, this depreciation is a sunken expense and is,
therefore, not applicable. If the equipment could be utilized to create another product,
this may be a relevant expense as well. Still, we suppose that the equipment has no
salvage value and no other use.

In addition, the company is setting aside a part of its general operating expenses, for
bearings. Any part of the general operating expenses that would be done away with if
the bearings were bought instead of made would be pertinent in this analysis. However,
the general operating expenses are possibly a common expense to all the company’s
goods produced in the factory and which would continue without changes even if the
bearings were bought from outside (is not relevant).

The variable cost (direct labor, direct material and variable overhead) can be prevented
if the business does not make the bearing. In addition, we suppose that the supervisor’s
salary can also be avoided. This is because at $40,000, it costs less to manufacture the
bearings internally than to purchase them from an external supplier.

In conclusion, it may be said, the make-or-buy decision is a very important decision with
respect to overall production strategy and the possible implications for asset levels,
employment levels and key competencies. Business accounting may appear to be an
easy set of equations mirroring the money that enters into a business and that which
flows out from it. However, in reality, there are countless intricacies associated with the
relationship between various kinds of income and costs. Complexity is particularly
obvious in make-or-buy. Considering these aspects, the make-or-buy decision should
be weighed with utmost care.