What is a Make-or-Buy Decision?
A make-or-buy decision refers to an act of using cost-benefit to make a strategic choice between manufacturing a product in-house or purchasing from an external supplier. It arises when a producing company faces a diminishing capacity, experiences problems with the current suppliers, or sees changing demand.
The make-or-buy decision compares the costs and benefits that accrue by producing a good or service internally against the costs and benefits that result from subcontracting. For an accurate comparison of costs and benefits, managers need to evaluate the benefits of purchasing expertise against the benefits of developing and nurturing the same expertise within the company.
- A make-or-buy decision refers to an act of choosing to develop a product in-house or outsource its production from external vendors.
- Companies use the total transaction costs accrued in developing products to reach a make-or-buy decision.
- Make-or-buy decisions reward firms with a competitive advantage and reduce the cost of production and capital investment.
Understanding Make-or-Buy Decisions
Managers must incorporate in-house production costs when considering in-house production. It includes all the transaction costs involved in creating the product or service. It can also include extra labor needed for production, monitoring costs, storage requirements costs, and waste product disposal costs resulting from the production process.
Similarly, businesses must focus on both the production and transaction costs when considering outsourcing from outside suppliers. For example, the product’s price, sales tax charges, and shipping costs must be factored in. Companies must also include inventory holding costs, which comprise warehousing and handling costs, as well as risk and ordering costs.
The make-or-buy decision is sometimes treated as a financial or accounting decision. While it is important to conduct an accounting assessment and settle for the low-cost approach, it is more crucial to understand the basis of the decision.
Thus, companies must consider the strategic dimension of make-or-buy choices because they determine the profitability of the company and play an important role in its financial health. They can impact corporate strategy, core competence, cost structure, customer service, and flexibility.
Make-or-Buy Decision Triggers
A company’s decision on whether to make or buy is based on its core competence. The production cost and quality problems are the major triggers of a make-or-buy decision. Other factors are managerial decisions and a company’s long-term business strategy that dictate the current operations pattern.
Historical policy decisions may also compel a company to consider in-sourcing or outsourcing. Businesses can use such patterns to procure some parts of services from outside suppliers regardless of the company’s capability. Within the framework, the trend towards in-sourcing can be attributed to better quality control, existing idle production capacity, or unsatisfactory performance of outside suppliers.
In contrast, factors that may trigger a company to outsource a part rather than produce internally include the need for multiple sourcing, lack of internal expertise, cost reduction, the introduction of a new product or modification of an existing product or service, and reduced risk exposure. A company with a previous reputation for successfully providing outsourcing services may be considered to sustain a long-term relationship.
Make-or-Buy Decision Criteria
Setting up a standard make-or-buy process that applies to all companies is a complicated process. It is partly due to companies’ distinct behavior patterns and the fact that businesses operate in different business environments that are unique to each business. However, cost accounting remains the primary dimension of the make-or-buy decision.
Companies evaluate outsourcing to determine if the current overhead costs can be minimized to access new resources. While cost remains the hallmark of any business decision, other factors such as strategic, technological, core competency, risks, and relationships, also constitute outsourcing decisions, not to mention factors involved in developing and introducing a new product.
For example, managers can consider research and development (R&D), design, engineering, manufacturing, and assembly as sources of production costs when conducting an actual cost analysis. The competitors’ financial capabilities and technological abilities should also be evaluated during a sourcing decision. Companies can evade the pitfalls typical with make-or-buy decisions when the cost is the only variable used when considering the technological aspects.
Benefits of a Make-or-Buy Decision
A make-or-buy decision framework relates to autonomy, and a company selects from the many advanced options to account for various factors associated with outsourcing.
1. Lower costs and higher capital investments
One of the most notable advantages that a company enjoys when embracing a make-or-buy decision approach is that it can lower costs and increase capital investments, regardless of whether it decides to make materials in-house or subcontract from an external vendor.
2. Source of competitive advantage
A rigorous make-or-buy analysis can also act as a source of competitive advantage. For example, a company can increase the value it delivers to customers and shareholders from its core service and skills. It can also stay flexible by adopting a make-or-buy decision approach.
Such a company is better placed to weather the storm of a market downturn. To realize the benefits, companies must consider the internal and external environment in which they operate. In particular, the culture in which such decisions are reached, and the agenda of the parties involved can influence the decisions and their implementation, as well as the sustainability of the policy.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: