A business organization faces a make-or-buy decision when it has to make a choice between manufacturing a product on its own, or purchasing it ready from an external supplier.
What is a make-or-buy decision?
A make-or-buy decision is the main quantitative method known that involves choosing whether to make or buy a product.
The firm has to consider the cost to purchase the product from a third-party supplier known as Cost to Buy (CTB) and the cost to produce the product in-house known as Cost to Make (CTM).
This decision is often complex, as there are a variety of factors to consider such as cost, quality, flexibility, risk, etc.
How to calculate Cost to Buy (CTB) and Cost to Make (CTM)?
To decide whether to make a product or to buy a product from another business, the firm needs to work out the following values of both situations using the following formulae:
Cost to Buy (CTB) = Price (P) x Quantity (Q)
Cost to Make (CTM) = Fixed Costs (FC) + (Variable Cost (AVC) x Quantity (Q)
So, now it is time to make a final decision:
1. Cost to Buy (CTB). When the firm is financially better off by buying the product, then the ‘buy’ decision is pursued. If Cost to Make (CTM) is greater than Cost to Buy (CTB), then it is more financially desirable to ‘buy’. If the cost of producing the product is greater than the supplier’s price, it makes more financial sense to buy the product rather than to make it. The buy decision should be made when a business does not have the expertise, equipment or productive capacity to efficiently manufacture a product.
Example 1: Apple considered its Cost to Make (CTM) the iPhone to be higher than to use Foxconn in China to manufacture the product.
2. Cost to Make (CTM). When the firm is financially better off by making the product, then the ‘make’ decision is pursued. If Cost to Buy (CTB) is greater than Cost to Make (CTM), then it is more financially desirable to ‘make’. If the cost of producing the product is lower than the supplier’s price, it makes more financial sense to make the product rather than to buy it. The make decision should be made when a business has the expertise, equipment or productive capacity to efficiently manufacture a product.
Example 2: A car manufacturer Toyota decides to make its own engines because Cost to Make (CTM) was lower than to purchase them from an external supplier.
What to consider in a make-or-buy decision?
The make-or-buy decision involves an assessment of both quantitative factors and qualitative factors.
Quantitative factors considered whether to make or buy a product include:
- Quantity. This includes the expected sales volume of the product, or quantity sold. It does not make much sense to start the entire production line to produce only few products in-house.
- Cost. This includes the direct costs of manufacturing such as material costs, labor costs as well as the indirect costs such as inventory management and quality control. It is also important to consider the cost of capital investment required to manufacture the product or component in-house including tools, equipment and machinery.
- Price. This includes the price per unit charged by the supplier.
Qualitative factors considered with a make-or-buy decision include:
- Quality. The quality of the product or component is critical to the success of the business. It is important to assess the quality capabilities of both internal and external suppliers to ensure that the product or component will meet the required quality standards. The relative product quality if produced in-house should be compared with an external supplier.
- Flexibility. The flexibility to respond to changes in demand and technology is also important. In-house manufacturing can provide more flexibility, but it may also be more expensive. Outsourcing to an external supplier can be more cost-effective, but it may make it more difficult to respond to changes quickly.
- Risk. There are risks associated with both making and buying. The risk of manufacturing a product or component in-house is that it may not meet quality standards or that it may be too expensive to produce. The risk of outsourcing to an external supplier is that the supplier may be unable to meet demand or that the quality of the product or component may be subpar. Is the decision reversible?
- Time. This includes the time-frame in which the products can be produced in-house compared with buying them from an external supplier. Also, whether the business has spare capacity to meet extra orders.
- Reliability. The reliability of suppliers is important when making the decision. Both their track record and reputation for delivering products on time should be considered. Suppliers might have greater flexibility to finish production on time.
Additionally, there are several other quantitative methods that can aid a make-or-buy decision such as Break-even Analysis and Investment Appraisal.
How to make a make-or-buy decision?
The best way to make a make-or-buy decision is to conduct a thorough analysis of the costs, benefits, and risks associated with both options. This analysis should include the following steps:
- Identify the product or component that is being considered for make-or-buy.
- Gather information on the costs, benefits, and risks of manufacturing the product or component in-house.
- Gather information on the costs, benefits, and risks of outsourcing the product or component to an external supplier.
- Compare the two options and select the one that is best for the business.
Make-or-buy decisions are an important part of business strategy regarding production of products. By carefully considering the costs, benefits, and risks involved, businesses can make the best decision for their specific needs.
