Cost Volume Profit
Make or Buy Decision
What Do We Mean by 'Make' and 'Buy' in Decision Making?
Make or Buy decisions means the difference between in-house production (make) or outsourcing the production (buy). In-House Production (Make) This refers to producing the entire product under the Company's control, in-house. In other words, the Company is able to transform raw materials into finished products in its own production facility. Outsourcing (Buy) This refers to buying key components or finished products from another manufacturer, to be resold at a higher price.
The business does not have to worry about getting raw materials for the product that is outsourced as it is delivered completely assembled and ready to go for its purpose. For example, a computer business could manufacture its own components (make) or purchase completely assembled computers from a manufacturer (buy) to be sold in its retail store.
Pros and Cons to Outsourcing (Buying)
Does not require capital investment
Stable variable cost for buying - The outsourcing cost is typically fixed.
Can be more cost efficient as it takes advantage of economies of scale - Can outsource to larger manufacturers who are able to produce the products or components more cheaply than in-house production.
Cannot easily change purchase volume
Delay in delivery of products - Can require shipping times or delay in changing contracted volumes.
Production cannot be easily customisable - The business does not control the production process. It cannot make customised or easily modify products that require a change in the production line.
Pros and Cons to Making (In-House Production)
Greater quality control of the production process - The business has full control of the production process and can determine the quality of the inputs and the quality control processes in place.
Greater volume control - Outsourcing is often reliant on fixed volume contracts. If producing in-house, the business can ramp up or reduce production accordingly to demand.
Requires Capital Investment - Producing in-house may require purchasing a specific plant, property or equipment.
Changing Variable Cost - If the cost of inputs increase or there is a disruption in the production process, the variable cost could change as a result.
Worked Example: Make or Buy Decision
HBC Phones manufactures high end smartphones. They currently manufacture the Display of the Phone but have an option to outsource the manufacturing from another supplier for $300 a unit.
The current cost of the Display in-house are outlined below:
Direct Materials: $100
Direct Labour: $30/hr at 5 hours per display
Fixed Costs: $300,000
If HBC Phones decide to outsource the display, fixed costs will reduce to $50,000.
HBC Phones sells 2,000 phones each year, requiring 2,000 displays.
Determine whether HBC Phones should make the Displays in-house or take up the Outsourcing Offer.
Step 1: Determine the Cost of In-House Production
Total Cost = Direct Materials + Direct Labour + Factory Overhead Direct Labour: $30/hr at 5 hours, per display. $30*5 = $150 per display.
Direct Materials: $100 Total Variable Cost Per Unit = $100 + $150 = $250/display
Total Variable Cost = $250 * 2,000 = $500,000
Total Cost = $500,000 (Variable Cost) + $300,000 (Fixed Cost) = $800,000
Step 2: Determine the Cost of Outsourcing
Variable Cost Per Unit = $300/display
Variable Cost = $300 * 2,000 = $600,000
Fixed Cost = $50,000
Total Cost = $600,000 (Variable Cost) + $50,000 (Fixed Cost) = $650,000
Step 3: Compare
In-House Production: $800,000 per year
Outsource: $650,000 per year
Outsource Cost Savings = $800,000 - $650,000 = $150,000
HBC Phones should outsource as this will produce a cost saving of $150,000 per year.