Make-or-buy decision analysis is an integral part of an organization’s strategic planning that helps them stay in business and profitable during market demand uncertainty, declining organization capability, and difficulties with suppliers.
Make-or-buy decisions require make-or-buy analysis.
Make-or-buy analysis is the process of gathering and organizing data about product requirements and analyzing them against available alternatives, including the purchase or internal manufacture of the product.
The make-or-buy decision is the act of choosing between manufacturing a product in-house or buying it from an external supplier.
This article explains make-or-buy analysis and provides examples, factors, templates, criteria, and how to conclude making or buying decisions.
How Do Make-or-Buy Decisions Work?
Definition: Make-or-buy decision analysis analyzes and compares the cost of manufacturing a product in-house with the cost of it buying from a supplier.
Service-based businesses analyze the cost of providing a service versus the cost of outsourcing.
A make-or-buy analysis aims to save costs and handle setbacks from suppliers.
Make-or-Buy Decision Analysis
Many factors affect the make-or-buy decision analysis.
For a “make” decision, manufacturing factors such as storage, waste product disposal, and monitoring costs are considered.
Costs for a “buy” decision can include the cost of the product, sales tax, and delivery fees.
Factors Favoring a “Make” Decision
These factors include:
When buying from outside sources is expensive, organizations opt for in-house production.
A Desire to Focus on Manufacturing
Organizations intending to venture into manufacturing will select the “buy” decision.
This is common in manufacturing industries. Here, businesses have doubts about the reliability of outsourcing partners. These doubts lead to in-house production.
Quality Control Requirements
When an organization carries out production activities, they have control over product quality. But when they outsource a part of the production, they don’t have control over the product quality. For the best quality control, in-house production is the best option.
This reason is usually overlooked when analyzing make-or-buy decisions. A company can decide to manufacture a product or offer a service based on emotional responses such as pride or contempt instead of logical reasoning.
Sometimes, transportation costs play a key role in the make-or-buy analysis. Unstable and high transportation costs can lead businesses to in-house production.
Other factors leading to a “make” decision include:
- Concerns about intellectual property
- Concerns about quality
- Inadequate supply of qualified suppliers
- To preserve a backup source
- Environmental considerations
- Political considerations
Factors Favoring a “Buy” Decision
These factors include:
Lack of Skills
When a business lacks skills for manufacturing a product, outsourcing is the best choice. Suppliers with expertise can offer the product cheaper; therefore, the “buy” option is best for a business.
When manufacturing a product or providing a service is expensive, businesses turn to outsource.
Lack of Facilities
Outsourcing is a better option when the business lacks facilities or capacity, equipment, resources, etc.
Low Demand Quantity
Depending on the product quantity, a company can outsource or decide to produce. For smaller quantities, businesses can go for a “buy” decision.
A product or service that isn’t essential to the core business is usually outsourced.
Other factors leading to a “buy” decision can include:
- Procurement and inventory considerations
- Preferences for certain brands
Examples of a Make-or-Buy Decision
ABC Manufacturing Company is contracted to supply 6,000 units of its MVP. This would also require 6,000 units of a component essential for the MVP. The estimated cost of manufacturing these 6,000 units of the necessary component is roughly 234,000 USD.
The direct material costs 10 USD per unit, amounting to 60,000 USD for 6,000 units, and direct labor costs of 8 USD per unit, totaling 48,000 USD. Applied Variables Factory Overhead costs 9 USD per unit, totaling 54,000 USD, and Applied Fixed Factory Overhead costs 12 USD per unit totaling 72,000 USD. There is also an additional 1.5 USD direct labor dollar at 39 USD, capping the total costs at 234,000 USD.
The same component may be acquired for 29 USD per unit on the market. If the component is purchased on the open market, it will save 25% of the factory’s fixed overhead.
Apple outsources some of its components and assembly from China.
China handles the production and assembly of many components of Apple’s products due to lower prices. Apple designs its product lines in California, manufactures them in China, and transports them back to the United States and other regions for sale.
Advantages of Make-or-Buy Decision Analysis
Some benefits of make-or-buy decision analysis are:
Make-or-buy decisions seek cost-effective methods in providing a product or service. Therefore, whether a business chooses to make goods or subcontract production to a third party, using a make-or-buy decision method can reduce prices and increase profitability.
Access to New Resources
Profits earned from make-or-buy decisions can be used to expand the business and gain new resources.
Helps in Strategic Planning
Businesses must investigate both their internal and external environments to receive the benefits. This is an important decision, and its outcome shapes the organization’s strategic planning.
Unnecessary Mistakes are Avoided
Make-or-buy decisions help businesses find the most viable alternative to clients with knowledge of their capacities. Mistakes happen when businesses take on more than they can handle, and a make-or-buy decision helps avoid this.
A make-or-buy analysis assists businesses in gaining a competitive advantage. A business can focus on its core activity, and the rest can be outsourced. It helps them reduce the cost and offers consumers a better product at a reduced price. It is a competitive advantage.
Make-or-Buy Decision Triggers
The primary motivators for a make-or-buy decision are cost and quality concerns. Managerial decisions and a firm’s long-term business plan are other variables that impact the decision.
Sometimes, previous policy decisions can compel in-house or outsourcing decisions.
On the other hand, factors such as the need for different suppliers, a lack of internal specialist knowledge, cheaper options, and reduced risk exposure may make a firm outsource instead of produce.
Many organizations go for “buy” but gradually shift to “make.” The shift toward in-house production can be caused by high-quality requirements, idle manufacturing capacity, or poor performance by outside manufacturers.
Make-or-Buy Decision Criteria
It is difficult to develop a generic make or buy framework because all businesses are unique and operate in different environments. However, the concept of make-or-buy decisions can be simplified into the cost-benefits analysis.
Cost is the prime factor; if a business sees savings in outsourcing, they will go for the “buy” decision.
Core competency, partnerships, risks, and technological and strategic factors also affect the make-or-buy decision.
During cost analysis, managers evaluate sources of production expenses, such as design, research and development (R&D), manufacturing, engineering, and assembly. When selecting a source, it is important to consider its financial and technological capabilities.
The make-or-buy decision should be made with caution, considering the core competencies of the organization and its strategic planning. Both choices have benefits and drawbacks; however, businesses select the choice that supports their objective and long-term goals.