Make or Buy Decision

Overview

The make or buy decision is a fundamental strategic choice faced by companies regarding the production of goods or components. When making this decision, a business must weigh the benefits of producing internally against the benefits of purchasing from an external supplier. Factors such as relevant costs, capacity, quality, and opportunity costs are essential in making an informed decision.

Detailed Explanation

Relevant Costs

Relevant costs in a make or buy decision include all the financial metrics directly associated with the production or procurement of an item. This encompasses materials, labor, overhead, and any additional cost reductions or increases that occur due to the decision.

Opportunity Costs

If a company is considering utilizing internal resources to manufacture a product instead of using them elsewhere, it must also consider the opportunity cost. This is the cost of not being able to apply those resources to a potentially more lucrative opportunity.

Planning and Strategy

The make or buy decision involves significant planning and strategic analysis, considering not only the financial aspects but also production capabilities and long-term business goals. Companies often face this decision when optimizing their manufacturing processes or when dealing with changes in market demand.

Examples

Automobile Manufacturing
- A car manufacturer might consider whether to make its own engines (considering costs, in-house technical expertise, and quality control) or buy them from an external supplier known for innovative engine technology.
Tech Industry
- A smartphone company deciding whether to produce its own chips can weigh the benefit of integrated design and performance versus purchasing high-quality, readymade chips from a specialist supplier.
Retail Chains
- A supermarket chain must decide whether to operate an in-house bakery (considering cost of setup, staffing, and ongoing operations) versus sourcing baked goods from an established, reliable wholesaler.

Frequently Asked Questions

What factors are considered in a make or buy decision?

When making a make or buy decision, factors including cost, quality, available capacity, control over production processes, and the impact on the existing workflow should be evaluated.

How do opportunity costs affect the make or buy decision?

Opportunity costs represent the benefits forgone by choosing one option over another. In the make or buy context, it accounts for the potential profits from alternative uses of the company’s resources.

Yes. Non-cost related reasons might include proprietary product advantages, quality control, intellectual property concerns, supplier reliability, and overall strategic alignment with long-term company goals.

Outsourcing: The practice of contracting business processes or functions to external suppliers.
Insourcing: The opposite of outsourcing; leveraging internal resources to perform tasks or produce goods.
Break-even Analysis: Financial calculations to determine the point at which revenue received equals the costs associated with receiving the revenue.
Differential Cost: The difference in total costs between two alternatives.
Supply Chain Management: Handling overall production flow from acquisition of raw materials to delivery of finished products.

Online References

Suggested Books

“Cost Accounting: A Managerial Emphasis” by Charles T. Horngren
- A comprehensive guide on cost accounting and related decision-making processes.
“Operational Excellence Handbook” by Karyn Ross
- Insight into efficient operations management, touching on relevant cost considerations.
“Managerial Accounting” by Ray H. Garrison
- Detailed discussions on cost analysis, budgeting, and strategic financial decisions.

Accounting Basics: “Make or Buy Decision” Fundamentals Quiz

### Which is the primary financial metric evaluated in make or buy decisions? - [ ] Revenue - [ ] Fixed Costs - [ ] Interest Rates - [x] Relevant Costs > **Explanation:** Relevant costs include the direct costs associated with making a product internally or buying it from an external source, and are the primary financial metrics evaluated for this decision. ### What is not typically considered in a make or buy decision assessment? - [ ] Cost of production - [ ] Capacity of internal production - [ ] Quality of internally produced goods - [x] CEO's personal opinion > **Explanation:** While important from a leadership perspective, the CEO's personal opinion is typically not an analytical factor. Objective cost, capacity, and quality analyses drive make or buy decisions. ### Opportunity cost is the: - [x] Foregone benefit of the next best alternative use of resources. - [ ] Additional cost incurred in choosing between two options. - [ ] Cost related to unexpected events during production. - [ ] Money lost from unfunded projects. > **Explanation:** Opportunity cost represents the financial benefits a company misses out on when choosing one alternative over another. ### Outsourcing in the make or buy decision refers to: - [ ] Increasing internal production. - [ ] Hiring more in-house staff. - [x] Contracting external suppliers for goods or services. - [ ] Expanding in-house processing capabilities. > **Explanation:** Outsourcing is the practice of contracting out parts of production or services to third-party suppliers. ### What can impact the make or buy decision beyond cost? - [ ] Market trends - [x] Quality control requirements - [ ] Employee opinions - [ ] External audits > **Explanation:** Quality control requirements are crucial in a make or buy decision, ensuring the resulting product meets company standards, which cost analysis alone may not address. ### Break-even analysis is useful in making make or buy decisions because it: - [ ] Measures market demand. - [ ] Predicts supply chain disruptions. - [x] Determines the point at which cost savings from making and buying equal out. - [ ] Assesses employee satisfaction. > **Explanation:** Break-even analysis helps to determine at what point the benefits of making a product equal the benefits of buying it, clarifying cost savings. ### Insourcing means: - [ ] Contracting external services. - [ ] Relocating production overseas. - [x] Utilizing internal resources for production. - [ ] Minimizing production steps. > **Explanation:** Insourcing refers to leveraging internal resources to perform tasks or produce goods, rather than outsourcing. ### When considering using spare capacity for a make decision, companies should: - [x] Include opportunity costs of alternative uses. - [ ] Disregard potential operational disruptions. - [ ] Neglect future capacity needs. - [ ] Rely solely on historical data. > **Explanation:** Considering the opportunity costs helps to evaluate the value of using spare capacity against other profitable uses for those resources. ### Which of the following is irrelevant in making a make or buy decision? - [ ] Production capacity - [x] Company logo - [ ] Relevant costs - [ ] Quality control standards > **Explanation:** The company logo does not influence the financial or operational considerations of whether to make or buy a component. ### A fundamental question in make or buy decisions is whether: - [ ] External suppliers have fewer benefits. - [ ] The production plant needs expansion. - [x] It is cost-effective to make internally versus buying. - [ ] The company brand image can be improved. > **Explanation:** The core of the make or buy decision revolves around the cost-effectiveness and strategic value of internal production versus external procurement.

Thank you for exploring this critical component of strategic manufacturing planning. Continue sharpening your financial and operational acumen with these resources and challenging quizzes!