What is a Make or Buy Decision?
A make or buy decision is a managerial accounting analysis that compares the relevant cost of producing a component in-house versus purchasing it from an outside supplier. It focuses only on costs that differ between the two alternatives, including any opportunity cost of freed-up capacity.
A make or buy decision compares the relevant (avoidable) cost of making a part internally to the cost of buying it externally, including the opportunity cost of any freed capacity; the cheaper relevant cost wins.
- •Variable production cost
- •Avoidable fixed costs (supervision, maintenance)
- •Ties up capacity & equipment
- •Full quality control
- •Purchase price per unit
- •Frees capacity for other uses
- •Opportunity cost of that capacity
- •Dependence on supplier reliability
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Step-by-step worked examples
A company can make a part for $8 variable cost/unit plus $20,000 avoidable fixed costs, needing 10,000 units. A supplier offers the part at $9/unit. There is no alternative use for the freed capacity. Should it buy?
Cost to make = (8×10,000) + 20,000 = 80,000 + 20,000 = 100,000 Cost to buy = 9×10,000 = 90,000 Since buying (90,000) is cheaper than making (100,000), buy the part — save $10,000.
Same numbers as above, but the freed factory space could be rented out for $15,000. Recompute the decision.
Relevant cost to buy = (9×10,000) − 15,000 = 90,000 − 15,000 = 75,000 Cost to make = 100,000 Buying is now even more favorable — save $25,000 instead of $10,000.
A firm makes 5,000 units at $12 variable cost + $30,000 avoidable fixed cost. A supplier quotes $16/unit with no opportunity cost. Make or buy?
Cost to make = (12×5,000) + 30,000 = 60,000 + 30,000 = 90,000 Cost to buy = 16×5,000 = 80,000 Buying saves 90,000 − 80,000 = $10,000, so buy.
Flashcards
Quick quiz
Q1.A part costs $10/unit variable plus $15,000 avoidable fixed cost to make 5,000 units. A supplier offers $12/unit. No opportunity cost. What is the relevant cost to make?
Q2.Using the same numbers, what is the cost to buy?
Q3.Should the company make or buy?
Q4.Which of these is IRRELEVANT to a make or buy decision?
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Common mistakes
Including all fixed costs, even unavoidable ones, in the make cost. — Correct: Only avoidable fixed costs that would disappear if you stop making belong in the comparison.
Ignoring the opportunity cost of freed capacity. — Correct: If freed capacity has an alternative use, its value must be subtracted from the cost of buying.
Letting sunk costs (like old machine purchase price) influence the decision. — Correct: Sunk costs are the same under both options and should be excluded.
Focusing only on unit price without considering total relevant costs. — Correct: Compare total relevant cost of making vs. buying, not just per-unit price.
FAQ
What is a make or buy decision?
It's a managerial accounting analysis comparing the relevant cost of producing a component internally versus purchasing it from an outside supplier.
What is the make or buy decision formula?
Compare relevant cost to make (variable cost × units + avoidable fixed costs) against relevant cost to buy (price × units − opportunity cost of freed capacity).
What are some make or buy decision examples?
A manufacturer deciding whether to produce its own packaging or outsource it to a supplier is a classic make or buy example.
How do you calculate a make or buy decision?
Subtract the relevant cost to buy from the relevant cost to make; a positive result means buying is cheaper.