by Make or Buy Decision is one of the most important applications of Marginal Costing in managerial decision-making. It refers to the decision whether a company should manufacture a product or component internally (Make) or purchase it from an outside supplier (Buy). The decision is made by comparing the relevant costs of manufacturing with the purchase price offered by external suppliers.
The primary objective of a make or buy decision is to minimize costs and maximize profits while ensuring quality and timely availability of materials or components.
Meaning of Make or Buy Decision
A make or buy decision involves choosing between two alternatives:
- Make Alternative: The company produces the component internally using its own resources.
- Buy Alternative: The company purchases the component from an external supplier.
The decision depends on which alternative results in lower costs and higher profitability.
Marginal Costing Approach to Make or Buy Decision
Under marginal costing, only relevant costs are considered. Fixed costs that remain unchanged irrespective of the decision are generally ignored.
Decision Rule
- Make if the marginal cost of manufacturing is less than the purchase price.
- Buy if the purchase price is less than the marginal cost of manufacturing.
Illustration
A company requires 10,000 units of a component annually.
Cost of Manufacturing per Unit
| Particulars | Amount (₹) |
|---|---|
| Direct Materials | 20 |
| Direct Labour | 15 |
| Variable Overheads | 10 |
| Fixed Overheads | 8 |
| Total Cost | 53 |
The component can be purchased from an outside supplier for ₹48 per unit.
Relevant Manufacturing Cost
20 + 15 + 10 = ₹45
Since fixed overheads are unavoidable and irrelevant, only ₹45 is considered.
Comparison
- Cost to Make = ₹45 per unit
- Cost to Buy = ₹48 per unit
Since the cost to make is lower, the company should manufacture the component internally.
Annual Savings
(₹48−₹45)× 10,000 = ₹30,000
Therefore, the company will save ₹30,000 annually by manufacturing the component
Objectives of Make or Buy Decision
- Minimization of Cost
The primary objective of a make or buy decision is to minimize the total cost of production. Management compares the cost of manufacturing a product internally with the cost of purchasing it from an outside supplier. The alternative that results in lower costs is selected. Cost minimization improves profitability and helps the organization remain competitive in the market. Therefore, reducing production costs and increasing operational efficiency is one of the most important objectives of a make or buy decision.
- Maximization of Profit
Another important objective of a make or buy decision is to maximize profits. By choosing the most economical alternative, management can reduce unnecessary expenses and increase contribution and profitability. Lower production costs enable the company to earn higher profits from its operations. Therefore, profit maximization is a significant objective that guides management in selecting between manufacturing and purchasing alternatives.
- Efficient Utilization of Resources
A make or buy decision aims to ensure the efficient utilization of available resources such as labour, machinery, and production capacity. If the company has idle resources, manufacturing the component internally may be more beneficial. On the other hand, if resources can be used more profitably elsewhere, purchasing may be preferable. Therefore, efficient utilization of organizational resources is an important objective of a make or buy decision.
- Better Utilization of Production Capacity
The decision also aims to utilize production capacity effectively. Organizations with excess or idle capacity often prefer manufacturing components internally to make better use of their facilities. Proper utilization of production capacity reduces wastage and improves operational efficiency. Therefore, maximizing the use of available production facilities is a major objective of a make or buy decision.
- Ensuring Continuous Supply
One of the objectives of a make or buy decision is to ensure the uninterrupted supply of materials and components required for production. Dependence on external suppliers may sometimes lead to delays or shortages. By manufacturing critical components internally, companies can maintain a continuous supply and avoid production disruptions. Therefore, ensuring regular availability of materials is an important objective of this decision.
- Improvement of Product Quality
A make or buy decision also focuses on maintaining or improving product quality. If the organization can produce a component with better quality standards than external suppliers, it may prefer internal manufacturing. Similarly, if suppliers provide superior quality products, purchasing may be more beneficial. Therefore, maintaining high-quality standards is another significant objective of a make or buy decision.
- Reduction of Business Risk
The decision aims to reduce business risks associated with production and supply. Relying completely on outside suppliers may expose the company to risks such as price fluctuations, supply shortages, and delivery delays. Internal production may reduce such risks. Therefore, minimizing operational and supply-related risks is an important objective of a make or buy decision.
- Supporting Strategic Business Decisions
A make or buy decision supports long-term strategic planning and organizational growth. Management considers future expansion plans, technological developments, market conditions, and competitive advantages before making the decision. Choosing the appropriate alternative contributes to long-term success and sustainability. Therefore, supporting strategic business decisions and improving organizational competitiveness is one of the most important objectives of a make or buy decision.
Factors Considered in Make or Buy Decision
- Cost Comparison
The most important factor in a make or buy decision is the comparison between the cost of manufacturing a product internally and the cost of purchasing it from an outside supplier. Management compares relevant costs such as direct materials, direct labour, and variable overheads with the supplier’s purchase price. The alternative that results in lower costs and higher profitability is generally selected. Therefore, cost comparison is the primary factor influencing the make or buy decision.
- Availability of Production Capacity
The organization must consider whether it has sufficient production capacity to manufacture the product internally. If there is idle or excess capacity, producing the component in-house may be economical. However, if the production facilities are fully utilized, purchasing from an outside supplier may be preferable. Therefore, availability of production capacity is an important factor in the decision-making process.
- Quality Requirements
Quality is another significant factor in make or buy decisions. Management must evaluate whether internally produced components meet the required quality standards or whether external suppliers can provide better-quality products. Poor-quality components can increase production costs and damage the company’s reputation. Therefore, quality considerations play a crucial role in determining whether to make or buy.
- Reliability of Suppliers
The dependability and reputation of external suppliers are important considerations. Management should assess whether suppliers can provide materials on time, maintain consistent quality, and ensure uninterrupted supply. Unreliable suppliers may cause production delays and operational disruptions. Therefore, supplier reliability significantly affects the make or buy decision.
- Availability of Skilled Labour and Technology
Internal production requires skilled employees, technical expertise, and appropriate technology. If the company lacks these resources, purchasing from a specialized supplier may be more economical. On the other hand, if the organization has adequate technical capabilities, manufacturing internally may be advantageous. Therefore, the availability of skilled labour and technology is an important factor.
- Confidentiality and Trade Secrets
Some products or components involve confidential processes, designs, or trade secrets that provide a competitive advantage. In such situations, companies may prefer to manufacture internally to protect proprietary information and avoid disclosure to outside suppliers. Therefore, confidentiality considerations often influence make or buy decisions.
- Continuity of Supply
Management must ensure that there will be a continuous and reliable supply of materials or components. Dependence on external suppliers may create risks such as shortages, delays, or supply interruptions. Internal production may provide greater control over the availability of essential components. Therefore, continuity of supply is an important factor in make or buy decisions.
- Strategic and Long-Term Considerations
A make or buy decision should also consider long-term strategic objectives, future expansion plans, market conditions, and competitive advantages. Sometimes an alternative that appears costlier in the short term may be more beneficial in the long run. Therefore, strategic and long-term considerations are essential factors influencing make or buy decisions.
Advantages of Make Decision
- Better Quality Control
One of the major advantages of the make decision is better control over product quality. When a company manufactures components internally, it can establish its own quality standards and monitor every stage of production. This reduces the chances of defects and ensures consistency in the final product. The company can also implement quality improvement programs whenever necessary. Better quality control enhances customer satisfaction and strengthens the organization’s reputation in the market. Therefore, maintaining superior quality standards is one of the most important advantages of making products internally.
- Utilization of Idle Capacity
The make decision helps organizations utilize their idle production capacity effectively. If machinery, labour, and facilities are underutilized, manufacturing components internally can increase productivity and reduce wastage of resources. Better utilization of existing resources lowers the average cost of production and improves profitability. Instead of leaving resources unused, companies can employ them for productive purposes. Therefore, effective utilization of idle capacity is a significant advantage of the make decision.
- Protection of Trade Secrets
Many organizations possess confidential designs, formulas, and manufacturing processes that provide them with a competitive advantage. By producing components internally, companies can protect these trade secrets from competitors and external suppliers. Internal production reduces the risk of leakage of sensitive information and preserves the uniqueness of products. Therefore, safeguarding proprietary information and maintaining confidentiality is an important advantage of the make decision.
- Greater Production Flexibility
Internal manufacturing provides greater flexibility in production operations. The company can quickly modify product designs, change production schedules, or adjust output according to market demand. Dependence on external suppliers often limits flexibility because suppliers may not be able to respond immediately to changing requirements. Therefore, the make decision allows organizations to adapt quickly to market conditions and customer preferences.
- Better Control over Delivery Schedules
When products are manufactured internally, management has greater control over production and delivery schedules. The company can ensure timely availability of components and reduce delays caused by external suppliers. Better control over deliveries improves production planning and helps meet customer commitments. Therefore, effective control over delivery schedules is a significant advantage of the make decision.
- Reduced Dependence on Suppliers
The make decision reduces the organization’s dependence on external suppliers. Excessive dependence on suppliers may expose the company to risks such as shortages, price increases, delivery delays, and supply disruptions. By manufacturing internally, the organization gains greater control over its production process and reduces external uncertainties. Therefore, reducing dependence on suppliers is another important advantage of making products internally.
- Development of Technical Skills and Expertise
Internal production provides opportunities for employees to develop technical knowledge and manufacturing skills. Continuous involvement in production activities enhances the organization’s technical capabilities and innovation potential. Over time, the company becomes more self-reliant and capable of producing high-quality products efficiently. Therefore, the development of technical skills and expertise is a valuable advantage of the make decision.
- Potential Cost Savings and Higher Profitability
If the cost of manufacturing a component internally is lower than the purchase price offered by external suppliers, the make decision can lead to substantial cost savings. Lower production costs improve contribution and profitability. In addition, efficient utilization of resources and elimination of supplier margins further reduce costs. Therefore, achieving cost savings and increasing profitability is one of the most significant advantages of the make decision.
Advantages of Buy Decision
- Avoids Heavy Capital Investment
One of the major advantages of the buy decision is that it avoids the need for heavy capital investment in machinery, equipment, and production facilities. Manufacturing a component internally often requires substantial investment in plant and technology. By purchasing from an outside supplier, the company can save this investment and use its funds for other productive purposes such as expansion, research, and marketing. Therefore, avoiding large capital expenditure is an important advantage of the buy decision.
- Reduces Production Burden
Purchasing components from external suppliers reduces the production burden on the organization. The company does not need to manage additional production processes, labour, and machinery for manufacturing the component. This enables management to focus on its core production activities and improve operational efficiency. Therefore, reducing the complexity and burden of production is a significant advantage of the buy decision.
- Allows Focus on Core Competencies
The buy decision enables an organization to concentrate on its core competencies and strategic activities. Instead of spending time and resources on producing every component internally, the company can focus on activities in which it has a competitive advantage. This specialization improves productivity, innovation, and profitability. Therefore, allowing the company to focus on its core business functions is one of the major advantages of purchasing components externally.
- Access to Specialized Suppliers
External suppliers often possess specialized technology, expertise, and advanced production techniques. By purchasing from such suppliers, the organization can obtain high-quality components that may not be possible to manufacture efficiently in-house. Specialized suppliers also benefit from economies of scale and extensive experience. Therefore, gaining access to specialized knowledge and superior products is an important advantage of the buy decision.
- Reduces Maintenance and Operating Costs
Internal production requires expenditure on machinery maintenance, repairs, utilities, and supervision. By choosing the buy alternative, the company can avoid these additional operating costs. This helps reduce administrative responsibilities and improves overall cost efficiency. Therefore, reduction in maintenance and operating expenses is another significant advantage of the buy decision.
- Provides Greater Flexibility
The buy decision provides flexibility because the organization can easily adjust the quantity purchased according to changes in market demand. Internal production may require fixed commitments to labour and machinery, whereas purchasing allows the company to increase or decrease orders as needed. Therefore, greater flexibility in responding to market conditions is an important benefit of buying from external suppliers.
- Saves Management Time and Effort
Manufacturing a component internally requires considerable managerial attention for planning, supervision, quality control, and maintenance. By purchasing externally, management can save time and effort and devote more attention to strategic activities such as product development, marketing, and customer service. Therefore, saving managerial time and resources is a valuable advantage of the buy decision.
- Reduces Inventory and Storage Requirements
The buy decision often reduces the need to maintain large inventories of raw materials and work-in-progress. Suppliers can provide components as and when required, reducing storage costs and inventory carrying expenses. Lower inventory levels also reduce the risk of obsolescence and wastage. Therefore, reducing inventory and storage requirements is one of the most important advantages of the buy decision.
Limitations of Make or Buy Decision
- Difficulty in Estimating Future Costs
One of the major limitations of the make or buy decision is the difficulty in estimating future costs accurately. Prices of raw materials, labour, and overheads may change due to inflation, technological developments, and market conditions. Similarly, supplier prices may also fluctuate over time. Incorrect cost estimates can lead to inappropriate decisions and reduce profitability. Therefore, uncertainty in future cost estimation is a significant limitation of the make or buy decision.
- Ignores Qualitative Factors
Make or buy decisions often focus mainly on quantitative factors such as cost and profitability while ignoring qualitative aspects like quality, supplier reliability, employee morale, and customer satisfaction. These factors can significantly influence the long-term success of the organization. A decision that appears economical in terms of cost may not always be beneficial from a strategic perspective. Therefore, ignoring qualitative factors is an important limitation of the make or buy decision.
- Changing Market Conditions
Business environments are highly dynamic and subject to continuous changes in demand, competition, technology, and government policies. A make or buy decision that is suitable today may become inappropriate in the future due to changing market conditions. Consequently, management may need to revise its decisions frequently. Therefore, uncertainty arising from changing market conditions limits the effectiveness of make or buy decisions.
- Dependence on Supplier Reliability
When the buy option is selected, the organization becomes dependent on external suppliers for timely delivery and quality of components. Supplier failures, delays, labour disputes, or financial difficulties may disrupt production operations. Such dependence can create operational risks and affect customer satisfaction. Therefore, reliance on supplier performance is a major limitation of the make or buy decision.
- Hidden and Indirect Costs
Some costs associated with make or buy decisions are difficult to identify and measure. Costs such as transportation, inspection, training, inventory carrying costs, and quality control expenses may not be included in the analysis. Ignoring these hidden costs can lead to inaccurate conclusions and poor decisions. Therefore, the existence of hidden and indirect costs is another important limitation of make or buy decisions.
- Inaccuracy of Cost Information
The effectiveness of a make or buy decision depends heavily on the accuracy of cost data. If cost information is incomplete, outdated, or incorrectly classified, the decision may not reflect the true financial impact. Inaccurate data can result in increased costs and reduced profitability. Therefore, dependence on accurate cost information is a significant limitation of make or buy decisions.
- Overlooks Long-Term Strategic Effects
Many make or buy decisions are based on short-term cost considerations and may overlook long-term strategic consequences. For example, outsourcing production may result in loss of technical expertise, reduced control over quality, or dependence on suppliers. Similarly, internal production may require substantial future investments. Therefore, failure to consider long-term strategic implications is an important limitation of make or buy decisions.
- Technological Changes May Affect the Decision
Rapid technological developments can quickly make existing production methods or supplier arrangements obsolete. A company that decides to manufacture internally may later find that external suppliers possess more advanced technology and can produce at lower costs. Similarly, purchased components may become outdated due to innovation. Therefore, technological changes create uncertainty and limit the long-term effectiveness of make or buy decisions.
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