Make-or-Buy Decision

Make-or-Buy decision (also called the outsourcing decision) is a judgment made by management whether to make a component internally or buy it from the market. While making the decision, both qualitative and quantitate factors must be considered.

Examples of the qualitative factors in make-or-buy decision are: control over quality of the component, reliability of suppliers, impact of the decision on suppliers and customers, etc.

The quantitative factors are actually the incremental costs resulting from making or buying the component. For example: incremental production cost per unit, purchase cost per unit, production capacity available to manufacture the component, etc.

The following example illustrates the numerical part of a simple make-or-buy decision.

Example

The estimated costs of producing 6,000 units of a component are:

 Per UnitTotal
Direct Material$10$60,000
Direct Labor848,000
Applied Variable Factory Overhead954,000
Applied Fixed Factory Overhead1272,000
$1.5 per direct labor dollar 
 $39$234,000

The same component can be purchased from market at a price of $29 per unit. If the component is purchased from market, 25% of the fixed factory overhead will be saved.

Should the component be purchased from the market?

Solution

 Per UnitTotal
 MakeBuyMakeBuy
Purchase Price $29 $174,000
Direct Material$10 $60,000 
Direct Labor8 48,000 
Variable Overhead9 54,000 
Relevant Fixed Overhead3 18,000 
Total Relevant Costs$30$29$180,000$174,000
Difference in Favor of Buying $1 $6,000

Written by Irfanullah Jan