10.3 Evaluate and Determine Whether to Make or Buy a Component
3 min read•june 18, 2024
Make-or-buy decisions are crucial for companies weighing against . These choices involve comparing , like materials and labor, while considering and ignoring sunk expenses. Smart decisions can lead to cost savings and strategic advantages.
Managers must balance , such as financial impact, with qualitative aspects like supplier reliability and long-term implications. By carefully evaluating both internal production and external purchasing options, companies can optimize their operations and maintain a competitive edge in the market.
Make-or-Buy Decisions
Costs in make-or-buy decisions
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- Relevant costs are the between making and buying a component
- Include (raw materials), (wages), and costs (utilities, supplies)
- Exclude (rent, salaries) that will not change based on the decision
- Opportunity costs should be considered
- Freeing up capacity for more profitable products (high-margin items) by outsourcing
- Lost contribution margin from reducing external sales of the component (selling to other companies)
- , such as equipment already purchased (machinery), should be ignored
- , such as equipment maintenance (repairs) or disposal (scrapping), should be included
Quantitative vs qualitative outsourcing factors
- Quantitative factors focus on cost savings and financial impact
- Compare the cost of making the component (in-house production) to the purchase price from suppliers ()
- Consider the impact on cash flow (liquidity) and requirements (inventory levels)
- Evaluate potential cost savings from (bulk purchasing) or specialization (expertise)
- address non-financial aspects and long-term implications
- Assess the reliability (on-time delivery) and quality (defect rates) of suppliers
- Consider the impact on flexibility (customization) and responsiveness to customer needs (lead times)
- Evaluate potential risks, such as loss of control over the supply chain (dependency) or (trade secrets)
- Analyze the effect on the company's (key strengths) and (long-term goals)
- Assess the impact on and overall
Internal production vs external purchasing
- Calculate the total relevant costs for making and buying the component
- of making = + + Variable manufacturing overhead + Opportunity costs - Avoidable costs
- Total relevant cost of buying = Purchase price + Ordering and receiving costs (handling) + Opportunity costs - Avoidable costs
- Compare the total relevant costs and select the option with the lower cost
- Consider strategic factors that may override the cost-based decision
- Maintaining control over quality (product standards) and intellectual property (patents)
- Developing or preserving core competencies (manufacturing expertise) and competitive advantages (differentiation)
- Ensuring long-term supply chain stability (multiple suppliers) and risk mitigation (contingency plans)
- Make the decision based on a combination of cost savings and alignment with the company's overall strategy and goals
Additional considerations
- : Evaluate how the affects the use of existing production capacity
- : Conduct a comprehensive assessment of both financial and non-financial factors
- Outsourcing: Consider the potential benefits and risks of delegating component production to external suppliers
Key Terms to Review (28)
Avoidable Costs: Avoidable costs are expenses that can be eliminated or reduced if a particular decision or action is taken. These costs are directly tied to a specific activity or decision and can be avoided by not undertaking that activity or making that decision. Avoidable costs are an important consideration in various managerial accounting contexts, including decision-making, make-or-buy analysis, and product or segment discontinuation.
Capacity Utilization: Capacity utilization refers to the extent to which a company is using its available productive capacity. It is a measure of how efficiently a company is utilizing its resources, such as machinery, equipment, and labor, to meet current levels of demand for its products or services.
Core Competencies: Core competencies are the fundamental capabilities, skills, and knowledge that provide a company with a competitive advantage. They are the essential areas of expertise that enable an organization to deliver unique value to its customers and differentiate itself from competitors.
Cost-Benefit Analysis: Cost-benefit analysis is a systematic process for calculating and comparing the benefits and costs of a decision, project, or policy. It involves quantifying the value of all the positive and negative consequences to determine whether the benefits outweigh the costs, helping organizations make informed and rational choices.
Differential Costs: Differential costs refer to the changes in total costs that occur when a business makes a decision to take on an additional activity or project. These costs are the incremental or marginal costs that are directly attributable to the decision being evaluated, such as whether to make or buy a component.
Direct labor: Direct labor refers to the wages and salaries of employees who are directly involved in the production of goods or services. This cost is directly traceable to specific products or jobs within a manufacturing environment.
Direct Labor: Direct labor refers to the cost of the workforce directly involved in the production of goods or the provision of services. It encompasses the wages and salaries paid to employees who physically transform raw materials into finished products or perform tasks that are essential to the completion of a service.
Direct materials: Direct materials are raw materials that can be directly traced to the production of a specific product. These materials are essential components in manufacturing and are included in the cost of goods sold.
Direct Materials: Direct materials are the raw materials that can be directly traced to the production of a specific product. They are a key component of product costs, along with direct labor and manufacturing overhead, and are a crucial element in understanding the differences between merchandising, manufacturing, and service organizations, as well as the various costing methods used in managerial accounting.
Economies of Scale: Economies of scale refer to the cost advantages that businesses can exploit by expanding their scale of production. As a company increases its output, its average costs per unit typically decrease due to more efficient utilization of resources and processes.
External Sourcing: External sourcing refers to the practice of obtaining goods, services, or components from outside the organization, rather than producing them internally. It involves leveraging the capabilities and resources of external suppliers or vendors to meet the organization's needs.
Fixed Overhead Costs: Fixed overhead costs are expenses incurred by a business that do not vary with the level of production or sales. These costs remain constant regardless of the output or activity level, and must be paid even if the business produces nothing. Understanding fixed overhead costs is crucial when evaluating whether to make or buy a component, as they are a key factor in the decision-making process.
In-House Production: In-house production refers to the manufacturing or assembly of a product or component within an organization's own facilities and resources, rather than outsourcing it to an external supplier or third-party vendor. It involves utilizing the company's internal capabilities, equipment, and workforce to create the desired items.
Intellectual Property: Intellectual property (IP) refers to the creations of the human mind, such as inventions, literary and artistic works, designs, and symbols, names, and images used in commerce. It is a legal concept that grants the creator of an original work exclusive rights to its use and distribution, typically for a limited period of time.
Make-or-Buy Decision: A make-or-buy decision is the strategic choice an organization faces between producing a component or service internally (making it) or obtaining it from an external supplier (buying it). This decision is a critical component of operations management and can have significant financial and operational implications for a business.
Opportunity Costs: Opportunity cost refers to the value of the next best alternative that must be forgone in order to pursue a certain action or decision. It represents the trade-offs involved in choosing one option over another, and the potential benefits that are sacrificed by not selecting the alternative option.
Outsourcing: Outsourcing is the business practice of contracting with an external organization or individual to perform tasks, provide services, or create goods that were previously handled internally. It is a strategic decision made by organizations to focus on their core competencies and leverage the expertise and resources of external providers.
Qualitative factors: Qualitative factors are non-numeric elements that influence decision-making and performance evaluation. These factors include aspects such as employee morale, customer satisfaction, and brand reputation.
Qualitative Factors: Qualitative factors are non-numerical, subjective considerations that play a role in decision-making processes. Unlike quantitative factors, which can be measured numerically, qualitative factors are more abstract and based on judgment, experience, and intuition. These factors are crucial in various managerial accounting contexts, as they provide a more holistic perspective to supplement the numerical data.
Quantitative Factors: Quantitative factors are measurable, numerical elements that are considered when evaluating and determining whether to make or buy a component. These factors provide objective, data-driven information to support decision-making in the make-or-buy analysis process.
Relevant Costs: Relevant costs are the future costs that are expected to change based on a decision being considered. These costs are important in evaluating alternative courses of action and making informed business decisions.
Strategic Focus: Strategic focus is the deliberate alignment of an organization's resources, activities, and decision-making towards the achievement of its long-term objectives and competitive advantage. It involves prioritizing and directing the organization's efforts towards the most critical and impactful areas that will drive success.
Sunk Costs: Sunk costs refer to expenses that have already been incurred and cannot be recovered, regardless of future decisions. They are past costs that are irrelevant for future decision-making as they do not affect the incremental costs and benefits of a decision. Understanding the concept of sunk costs is crucial in various managerial accounting contexts, such as identifying relevant information for decision-making, evaluating make-or-buy decisions, determining whether to keep or discontinue a segment or product, and assessing whether to sell or process a product further.
Supply Chain Management: Supply chain management is the oversight and coordination of the flow of goods, services, information, and finances from the initial supplier to the final customer. It involves the management of all activities and resources necessary to deliver products and services to consumers.
Total Relevant Cost: Total Relevant Cost refers to the sum of all costs that are relevant or important in the decision-making process, particularly in the context of evaluating whether to make or buy a component. It encompasses the direct and indirect costs associated with a decision, focusing on the costs that will change as a result of the decision being considered.
Variable Manufacturing Overhead: Variable manufacturing overhead refers to the indirect production costs that fluctuate in proportion to changes in the level of production activity. These costs vary with the volume of goods produced and include items such as indirect materials, indirect labor, and variable factory utilities.
Vertical Integration: Vertical integration is a business strategy where a company owns or controls its entire supply chain, from the production of raw materials to the distribution and sale of the final product. This allows the company to have greater control over the production process, reduce costs, and potentially gain a competitive advantage.
Working Capital: Working capital refers to the difference between a company's current assets and current liabilities. It represents the liquid resources available to a business to fund its day-to-day operations and meet its short-term obligations. Working capital is a crucial metric in evaluating a company's financial health and liquidity position.