Make-or-Buy Business Decision

See Also:
Company Life Cycle
Market Positioning
Marking to Market
Mining the Balance Sheet for Working Capital
Inventory to Working Capital

Make-or-Buy Business Decision

Make-or-buy decisions arise in business when a company must decide whether to produce goods internally or to purchase them externally. This typically is an issue when a company has the ability to manufacture material inputs required for its production operations that are also available for purchase in the marketplace. For example, a computer company may need to decide whether to manufacture circuit boards internally or purchase them from a supplier.
When analyzing a make-or-buy business decision, look at several factors. The analysis must examine thoroughly all of the costs related to manufacturing the product as well as all the costs related to purchasing the product. Such analysis must include quantitative factors and qualitative factors. The analysis must also separate relevant costs from irrelevant costs and look only at the relevant costs. The analysis must also consider the availability of the product and the quality of the product under each of the two scenarios.

Quantitative vs. Qualitative Analysis

The make-or-buy decision involves both quantitative analysis and qualitative analysis. You can calculate and compare quantitative considerations. Qualitative considerations require subjective judgment and often need multiple opinions. Also, some of the factors involved can be quantified with certainty, while other factors must be estimated. The make-or-buy decision requires thorough analysis from all angles.
Quantitative factors to consider may include things such as the availability of production facilities, production capacity, and required resources. They may also include fixed and variable costs that can be determined with certainty or estimated. Similarly, quantitative costs include the price of the product under consideration as it is being priced by suppliers offering the product in the marketplace for sale.
Qualitative factors to consider require more subjective judgment. Examples of qualitative factors include the reputation and reliability of the suppliers, the long-term outlook regarding production or purchasing the product, and the possibility of changing or altering the decision in the future and the likelihood of changing or reversing the decision at a future date.

Relevant Costs and Irrelevant Costs

When making the make-or-buy decision, it is necessary to distinguish between relevant and irrelevant costs. Relevant cost for making the product are all the costs that could be avoided by not making the product as well as the opportunity cost incurred by using the production facilities to make the product as opposed to the next best alternative usage of the production facilities. Relevant costs for purchasing the product are all the costs associated with buying it from suppliers. Irrelevant costs are the costs that will be incurred regardless of whether the product is manufactured internally or purchased externally.
After you’ve identified the relevant costs and irrelevant costs in your company, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.