Make-or-buy analysis

The make-or-buy analysis is an analysis in which we determine the costs and risks associated with the production or creation of a service within our organization.These costs are compared with the expenses that we would have incurred when purchasing the product from external suppliers. Genesis of make-or-buy analysis

Many authors in the field of finance or accounting have discovered many aspects related to the impact of various calculation systems, return calculations, etc.An early study of the issues discussed was published in 1942 by Professor Cullton of Harvard University. He compared companies in the eastern United States, which operated in the first half of this century and grouped factors in three categories: cost, quality and quantity.He felt compelled to draw a conclusion (from which it appeared that the purchase became more preferred than making), and even more so to observe that the make-or-buy decision depends on the current economic, social and political situation. Consequently, the conclusions of such a review should be periodically reviewed.

Another useful accountant from the accounting point of view was published by Anthony Gambino in 1980 on behalf of the National Association of Accountants in the US and the Canadian Accountants' Management Society. This work focuses heavily on the financial aspects of make-or-buy.

Decision: to produce or buy?

Make (production) - allows the company to control its activity.It is especially recommended when the company has proprietary products or processes.It is recommended when:

• The environment is stable
• The supplier market is not very developed,
• The product is valuable and difficult to copy.

Buy (purchase) - purchasing products and services from external partners in the supply chain increases the flexibility of the company and gives it access to the most modern products.It is recommended when:

• There is competition on the supplier market
• The product is not seen as strategically important
• The uncertainty of the environment makes internal investments risky

The basis of make-or-buy comparisons are the total production and purchase costs calculated for comparable batches of products. By default, the basic economic argument provides a simple comparison of the unit purchase price with the unit variable production cost. If we find that the unit variable production cost is greater than or equal to the price of the purchased good, production is economically unjustified.In the full analysis, in addition to the variable production costs, we must additionally consider what part of the company's fixed costs should be added to the settlement of total production costs. Below is a comparison scheme that is the basis for the decision to "produce" or "buy". The calculation of production costs shows that,

Cp = Cf + V ∙ Cv 

Where:

• Cp - total cost of production x units of good
• Cf - fixed production costs
• V - expected production volume
• Cv - unit variable costs

For purchase cost:

Cp = p ∙ v 

Where:

• Cp - purchase cost
• p - unit price,
• v - volume of purchase (production)

We can also meet the problem if the production capacity should be invested and produced. In this case - after considering all the substantive arguments that support the investment and do not exclude the expediency of purchase - the cost analysis should include the components of the investment account.

Strategic role of make-or-buy decisions

As you can see, make-or-buy decisions can be strategic decisions regarding the functioning and even the future of the company. Nowadays, on the market of huge competition, where companies are fighting for customers, they try to produce every good at the lowest price and very good quality. This means that large corporations often give up the production of semi-finished products for small businesses. What should be taken into account in the make-or-buy analysis on the example of services

Consider the example of a cleaning service. Let us assume that our own resources provide the company's cleaning service, but we are preparing to take it out. What elements do we need to look at before making the final decision on outsourcing?

• Availability of potential suppliers (i.e., how many companies on the market are able to provide a given service, which we analyze)
• The costs of running this service on your own (i.e., how much the employees of the people involved in the service cost us, what are the costs associated with the purchase of products for the given service)
• The risk of absenteeism (that is, what can happen if, for example, persons responsible for the service are on vacation or holidays)
• Risk related to the quality of the service (that is, what will happen if the quality of the service provided by the outside company is insufficient)
• Costs related to obtaining the service from external suppliers (i.e., examine potential competition through the request for quotation and inviting suppliers for a local vision)

In projects, we can meet a situation when we have to choose between an existing solution and the creation of a new one. In this way, we use the make-or-buy analysis, taking into account the key features of the project. 

Make-or-buy analysis — recommended articles

Economic feasibility — Make-Or-Buy Decision — Cost per unit — Standard price — SPACE method — Make or buy decision — Market structure — Supplier — Feasibility analysis