What are the type of decisions about whether a firm should make or buy the component parts that go into the final product known as?

Make or Buy Decision Meaning

A Make or Buy Decision is a decision made to either manufacture a product/ service in house or buy it from outside suppliers (outsourcing) based on cost-benefit analysis. A complete or accept decision can be made using quantitative or qualitative research and most of the time, the results of quantitative analysis (cost-benefit analysis) are enough to decide on whether to make the product in-house or buy (outsource) from outside suppliers.

How Does Make or Buy Decision Work?

The decision applies to both goods and services. Businesses compare the cost and benefits of producing the goods or services within the company and the cost and benefits of getting an outside supplier to supply the goods and services into consideration. The value here must include all the fees associated with manufacturing (including material, labor, cost of machinery and space), storing, moving, taxes, etc. and the corresponding benefits must include benefits in terms of increased margins (for in-house production) or low capital requirement (for outsourcing).

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Analysis for Make or Buy Decision

Let’s discuss the analysis of make or buy decisions.

• Under quantitative analysis, businesses consider all the costs associated with producing the product or service in-house. These costs include buying and maintaining equipment, cost of the premises (lease, etc.), raw material cost, conversion costConversion cost is incurred by any manufacturing entity in converting its raw material into finished goods sold in the market and includes labour cost and other applied overheads like factory overheads and administrative overhead. Conversion cost = manufacturing overheads + direct labourread more, cost of fuel and electricity, labor cost, warehousing or storage cost, shipping cost, and the cost of capitalThe cost of capital formula calculates the weighted average costs of raising funds from the debt and equity holders and is the total of three separate calculations – weightage of debt multiplied by the cost of debt, weightage of preference shares multiplied by the cost of preference shares, and weightage of equity multiplied by the cost of equity.read more. The benefits include higher margins from in-house production.
• The cost associated with outsourced production includes the product and service, transportation, warehousing, and storage and labor costs for managing the logistics.
• The decision becomes a little straightforward if the company does not have an idle capacity to produce the product or service. In this case, the management can opt to hire an outside supplier considering that it is not of critical importance, and the firm’s intellectual property is not endangered.
• Considering the company has the idle capacity, and it is already incurring a large part of fixed expenses, it can choose to manufacture in the house if the marginal cost of manufacturing is less than what it will cost to buy from outside suppliers.

Examples of Make or Buy Decision

Lest discuss examples of make or buy decisions for better understanding.

Make or Buy Decision Example #1

As stated earlier, there may be some factors at play that may influence a company’s company’s decision to make an item in the house or outsourcing it.

Under such circumstances, two factors are to be considered:

1. Whether surplus capacity is available and
2. The marginal cost of per unit manufacturing

Assume a company is deciding between manufacturing a part in-house that costs $26 per unit, including direct cost, fixed overheads, and variable overheads, as given in the table below.

The same part is available in the market at $23 per unit, including the cost of buying, shipping, and warehousing, as shown in the table below.

Should the Firm Make or Buy the part?

Analysis

If surplus capacity available will remain idle if the component is bought, out of pocket expensesOut-of-pocket expenses are the expenses that an employee pays out of their own pocket and then gets reimbursed from their employer. Transportation, meals, and lodging expenses are common examples.read more will be $23 per unit, $1 more than the variable and direct cost of making component which is $22 ($15 + $7). Hence it is economical to make it. However, if the Firm is utilizing or can utilize the capacity in making some other part which contributes to say $4 per unit in profits, the effective cost of buying the component will be $19 ($23 less $4 contribution from other products). In that case, it would be economical to buy the Component at $23 per unit from outside.

The relevant calculation for making decision may be as follows:

Make or Buy Decision Example #2

The smartphone giant Apple Inc. outsources the manufacturing of all its devices to China because manufacturing is not its core competencyThe core competencies in business refer to its resources and unique fundamental capabilities that distinguish it from market competitors. It is an essential component of marketing strategy leading to brand recognition and business growth. The concept serves to be useful for companies focusing on multiple product lines and operating more than one business unit at a time. read more. It is also significantly cheaper to assemble the tools in China due to substantially lower costs. Apple designs its produces in its office in the United States; the products are then manufactured in China and shipped back to the United States and other countries for sales.

Factors Considered for Make or Buy Decision

The following are the major factors considered while deciding to make the good or service in-house.

• Cost concerns (when it is expensive to outsource)
• Desire to enhance the manufacturing focus
• Intellectual property concerns
• Quality concerns
• Unreliable suppliers
• The need for direct quality control over the product
• Emotional reasons (for example, pride)
• Absence/shortage of competent suppliers
• Insignificant volume for a prospective supplier
• Reduction of shipping and transportation costs
• For maintaining a backup source
• Environmental reasons
• Political reasons

The following are the major factors considered while deciding to buy the good or service from the outside supplier.

• Lack of expertise
• Research and specialized know-how of the supplier better than the buyer
• Cost considerations (cheaper to buy the item)
• Insufficient or no manufacturing capacity at the buyer’s end
• De-Risking the sourcing
• Low-volume requirements
• The supplier is more equipped than the buyer
• Procurement and inventory considerations
• Product or service not essential to the firm’s strategy
• Preference of Brand

Advantages of Make or Buy Decision

Some of the advantages of making or buy decisions are as follows:

• The finding helps choose the most efficient option to go about in-house production of outsourcing.
• The decision helps in the strategic maneuver of the business.
• The decision helps save the cost for many businesses.
• Businesses benefit from the lower cost of mistakes if they think strategically about this decision.

Conclusion

The make or buy decision should be taken with utmost care keeping the long-term and short-term benefits into consideration. There are pros and cons to both make and purchase; however, generally, businesses tend to outsource function where they do not have a core competency or when the cost of procuring the components or services from outside suppliers is significantly cheaper.

Recommended Articles

This has been a guide to what is make or buy decision and its meaning. Here we discuss how does make or buy decision works along with its factors and examples. You can more about finance from the following articles –

• In House Financing
• Examples of Cost-Benefit Analysis
• Examples of NPV
• Incremental IRR
• Decile