Make or buy decision

Make or Buy Decision: Definition, Formula, Example, and FAQs

A make or buy decision is a crucial strategic choice faced by businesses when determining whether to produce a good or service internally or to purchase it from an external supplier. This decision falls under the broader umbrella of managerial accounting and involves a comprehensive cost analysis to identify the most economically advantageous option. The make or buy decision impacts various aspects of a company's operations, including production efficiency, quality control, and overall profitability. Companies undertake a make or buy decision to optimize resource allocation, reduce expenses, and focus on their core business activities.

History and Origin

The theoretical underpinnings of the make or buy decision are deeply rooted in the concept of transaction cost economics, a field pioneered by Nobel laureate Ronald Coase in the late 1930s and significantly expanded upon by Oliver Williamson. Coase's seminal work explored why firms exist and what determines their boundaries, essentially asking when it is more efficient to organize production within a firm (make) rather than through market transactions (buy). Williamson further developed this theory, for which he was awarded the Nobel Memorial Prize in Economic Sciences in 2009, by analyzing economic governance, particularly the "boundaries of the firm."

Williamson’s work focused on how different governance structures—markets versus hierarchies (firms)—organize transactions to minimize associated costs, including those beyond just production, such as search, bargaining, and enforcement costs. His i¹⁰nsights provided a robust framework for understanding the economic rationale behind a company's decision to internalize or externalize specific activities. This ⁹perspective highlighted that the make or buy decision is not merely about direct manufacturing costs but also about the transactional efficiencies and inefficiencies inherent in different organizational forms.

K⁸ey Takeaways

• The make or buy decision evaluates whether to produce goods/services internally or acquire them externally.
• It involves analyzing both quantitative (costs, capacity) and qualitative (quality, control, strategic fit) factors.
• The goal is to optimize costs, enhance efficiency, and align with a company's strategic objectives.
• Key considerations include existing capacity, available expertise, long-term costs, and the importance of the activity to core competencies.
• Misjudging a make or buy decision can lead to higher costs, reduced quality, or loss of competitive advantage.

Formula and Calculation

The make or buy decision typically involves comparing the total cost of making an item versus the total cost of buying it. The relevant costs considered are usually differential costs, meaning only those costs that will change based on the decision.

Cost of Making (Internal Production):
The cost of making an item internally includes:

• Direct Materials (DM)
• Direct Labor (DL)
• Variable Manufacturing Overhead (VMO)
• Avoidable Fixed Manufacturing Overhead (FMO_avoidable)
• Opportunity Cost of Facilities (OC_facilities), if applicable

$\text{Total Cost to Make} = (\text{DM} + \text{DL} + \text{VMO} + \text{FMO}_{\text{avoidable}}) \times \text{Units} + \text{OC}_{\text{facilities}}$

Here:

• Direct Materials (DM): The raw materials directly used in the production of each unit.
• Direct Labor (DL): The labor costs directly attributable to producing each unit.
• Variable Manufacturing Overhead (VMO): Production costs that vary with the volume of output, such as indirect materials or utilities directly tied to production.
• Avoidable Fixed Manufacturing Overhead (FMO_avoidable): Fixed costs that can be eliminated if the company decides to buy instead of make (e.g., specific equipment depreciation, supervisor salaries). Fixed costs that remain constant regardless of the decision (unavoidable fixed costs) are irrelevant to the analysis.
• Opportunity Cost of Facilities (OC_facilities): The benefit foregone by using internal facilities for this production rather than for their next best alternative use (e.g., renting out the space, producing another profitable product). This is particularly relevant if the decision requires significant capital expenditure or reallocation of existing assets.

Cost of Buying (External Purchase):
The cost of buying an item from an external supplier generally includes:

• Purchase Price per Unit (PP)
• Delivery Costs (DC)
• Other Variable Costs (OVC) related to procurement or handling

$\text{Total Cost to Buy} = (\text{PP} + \text{DC} + \text{OVC}) \times \text{Units}$

Here:

• Purchase Price per Unit (PP): The price charged by the external supplier for each unit.
• Delivery Costs (DC): Transportation and logistics expenses for acquiring the units.
• Other Variable Costs (OVC): Any additional variable costs incurred, such as inspection, handling, or administrative costs associated with purchasing.

By calculating and comparing "Total Cost to Make" and "Total Cost to Buy," management can ascertain the financially optimal choice.

Interpreting the Make or Buy Decision

Interpreting the make or buy decision goes beyond a simple financial calculation. While a lower numerical cost is a strong indicator, companies must also consider strategic and qualitative factors. If the "Total Cost to Buy" is significantly lower than the "Total Cost to Make," it generally suggests that outsourcing is the financially superior option. Conversely, if internal production is cheaper, making the product might be preferred.

However, the analysis extends to factors such as control over quality control, intellectual property, and adherence to production schedules. A company might accept a slightly higher internal cost to maintain proprietary processes or ensure consistent product standards. Furthermore, the capacity utilization of existing facilities plays a role. If a company has idle capacity, making the product might incur only variable costs, making it more attractive. Conversely, if internal production requires significant new investment or stretches existing resources, buying might be more prudent, even if the direct per-unit cost seems higher. Evaluating potential economies of scale for both internal production and external suppliers is also critical.

Hypothetical Example

Consider "SmoothieKing," a company that sells pre-packaged fruit smoothies. Currently, SmoothieKing purchases its custom-designed bottles from an external supplier for $0.15 per bottle. They use 1,000,000 bottles annually.

The management is considering a make or buy decision to produce the bottles in-house. They estimate the following costs for internal production:

• Direct Materials: $0.05 per bottle (plastic pellets)
• Direct Labor: $0.03 per bottle (machine operators)
• Variable Manufacturing Overhead: $0.02 per bottle (utilities, indirect supplies)
• Avoidable Fixed Manufacturing Overhead: $20,000 per year (salary of a supervisor who would be hired specifically for bottle production; this cost is only incurred if they make).
• Unavoidable Fixed Manufacturing Overhead: $50,000 per year (factory rent that would be paid regardless of this decision; irrelevant for this specific decision).
• Opportunity Cost: The space could be rented for $10,000 annually if not used for bottle production.

Let's calculate the total cost for 1,000,000 bottles:

Cost to Buy:

• Total Purchase Cost = $0.15/bottle × 1,000,000 bottles = $150,000

Cost to Make:

• Direct Materials = $0.05 × 1,000,000 = $50,000
• Direct Labor = $0.03 × 1,000,000 = $30,000
• Variable Manufacturing Overhead = $0.02 × 1,000,000 = $20,000
• Avoidable Fixed Manufacturing Overhead = $20,000
• Opportunity Cost = $10,000
• Total Cost to Make = $50,000 + $30,000 + $20,000 + $20,000 + $10,000 = $130,000

In this hypothetical example, the "Total Cost to Make" is $130,000, while the "Total Cost to Buy" is $150,000. Based purely on these production costs, SmoothieKing would save $20,000 annually by making the bottles in-house. This decision would also need to consider other factors not reflected in the immediate cost numbers, such as the initial investment in equipment, potential impact on their financial statements, and long-term strategic fit.

Practical Applications

The make or buy decision is a recurring and critical process across various industries and business functions. In manufacturing, companies frequently evaluate whether to produce components in-house or source them from specialized suppliers. This decision is central to supply chain management, influencing logistical efficiency, inventory levels, and dependency on external partners. For instance, a major automotive manufacturer might decide whether to build its own engines or purchase them from an engine specialist, weighing the costs, technological expertise, and strategic importance of engine production.

Beyond manufacturing, the make or buy decision extends to services and software development. Many companies consider whether to develop proprietary software internally or license off-the-shelf solutions. Similarly, administrative functions like human resources, IT support, or customer service often involve a make or buy evaluation. Companies also apply the make or buy framework in areas like marketing, research and development, and even transportation logistics. The choice affects a company's ability to achieve a competitive advantage by allocating resources effectively and focusing on activities that truly differentiate them.

A prominent real-world example of a significant make or buy decision involves Intel, the U.S. chipmaker. Intel has historically manufactured most of its own advanced chips, a core aspect of its business model. However, recent challenges and intense competition have prompted the company to re-evaluate its strategy. In July 2025, Intel warned investors that it might be forced to exit the cutting-edge chip manufacturing business if it fails to secure sufficient external customers for its advanced "14A" process, a move that would represent a historic shift for the company. This sign⁷als a potential pivot towards a "buy" strategy for its most advanced chip production, becoming more reliant on third-party foundries like TSMC, which could lead to significant financial impairments related to its manufacturing assets. Such a de⁴, ⁵, ⁶cision, as reported by Reuters, underscores the massive financial and strategic implications involved in a company's make or buy choices.

Limit³ations and Criticisms

While the make or buy decision framework provides a valuable structure for analysis, it has several limitations and criticisms. A primary critique is that it often overemphasizes quantitative fixed costs and [variable costs], potentially overlooking crucial qualitative factors. Over-reliance on cost savings alone can lead to unintended consequences, such as a loss of control over product quality, reduced flexibility, or the forfeiture of proprietary knowledge. For example, outsourcing a key component might initially save money but could expose intellectual property or reduce the company's ability to innovate in that area over time.

Another limitation is the difficulty in accurately forecasting all relevant costs and benefits, especially over the long term. Hidden costs associated with external suppliers, such as contract management, communication overhead, and potential supply chain disruptions, may not be fully captured in the initial analysis. Conversely, the true opportunity cost of internal resources can be challenging to quantify accurately. Furthermore, the decision often requires companies to consider factors beyond simple economic efficiency, such as the evolving nature of organizational boundaries, which are complex, socially constructed, and can have fundamental effects on organizational life. This broa¹, ²der perspective acknowledges that strategic autonomy, brand reputation, and the potential impact on employee morale are significant considerations that a purely financial make or buy model may not fully address. Therefore, effective risk management requires a holistic view, not just a numerical comparison.

Make or Buy Decision vs. Outsourcing

While often used interchangeably, the terms "make or buy decision" and "outsourcing" have distinct meanings. The make or buy decision is the fundamental strategic choice a company faces: should we produce this item/service ourselves (make) or acquire it from an outside provider (buy)? It is the initial analytical process that leads to a conclusion.

Outsourcing, on the other hand, is the act of engaging an external third party to perform a function or provide goods that were previously performed internally or could potentially be performed internally. It is the action taken as a result of a "buy" decision. All outsourcing decisions are make or buy decisions, but not all make or buy decisions result in outsourcing. For instance, a company might decide to "make" a new product in-house, which is a make or buy decision, but it doesn't involve outsourcing. Conversely, if the company decides to "buy" a component it used to manufacture, it is making a make or buy decision that leads to outsourcing. The key difference lies in the scope: "make or buy" is the analytical framework, while "outsourcing" is a specific strategy implemented when the "buy" option is chosen.

FAQs

What are the main factors in a make or buy decision?

The main factors in a make or buy decision include quantitative aspects like [production costs], existing capacity, and potential capital investment, as well as qualitative aspects such as quality control, control over intellectual property, strategic importance to the business, supplier reliability, and the potential impact on employees.

How does capacity affect the make or buy decision?

Existing unused production capacity can favor making a product in-house, as the company avoids the need for new significant [capital expenditure] and can utilize existing resources more efficiently. If current capacity is insufficient or fully utilized, buying from an external source may be more practical, even if the per-unit cost is slightly higher.

Is the make or buy decision only about cost?

No, the make or buy decision is not solely about cost. While cost is a primary consideration, companies must also weigh strategic factors such as maintaining a [strategic planning] edge, managing supply chain risks, ensuring product quality, protecting proprietary technology, and focusing on core business activities. A thorough [return on investment] analysis often includes both financial and non-financial benefits.

Can a make or buy decision be reversed?

Yes, a make or buy decision can be reversed, but doing so often involves significant costs and operational disruptions. Reversing a "make" decision to "buy" might require liquidating assets or laying off staff. Reversing a "buy" decision to "make" could entail substantial investment in new facilities, equipment, and training. Therefore, such decisions are typically made with a long-term perspective.