Make or Buy Decision
Outsourcing analysis — compare relevant make costs vs. buy price, including avoidable fixed costs and opportunity cost of capacity.
Why This Matters
Many businesses face the question: "Should we keep making this component ourselves, or should we buy it from a supplier?"
The answer depends on more than just the supplier's quoted price. You must compare the relevant costs of making internally versus buying externally, including avoidable variable and fixed production costs, additional buying costs, and opportunity costs of using internal capacity for something else.
Relevant Costs in Make-or-Buy
For each option, include only costs and benefits that differ.
Make (In-House)
- → Direct materials for the component
- → Direct labor for the component
- → Variable manufacturing overhead
- → Avoidable fixed overhead (supervisor, cancellable lease)
- → Opportunity cost of capacity (profits from alternative use)
Buy (Outsource)
- → Purchase price (per unit × units needed)
- → Shipping, receiving, and inspection
- → Additional handling or storage costs
- → Any new fixed costs (contract management, auditing)
- → Opportunity benefits from freeing capacity (higher-margin production)
Costs that are the same under both options (general factory rent, common administrative overhead) are irrelevant.
Quantitative Example — ABC Coffee Shop: Bottled Cold Brew Labels
ABC currently prints its own custom labels. A supplier offers to provide them. Units needed: 50,000 labels/year.
Make Option
DM $0.06 + DL $0.03 + VOH $0.01 = $0.10/label
Variable total: 50,000 × $0.10 = $5,000
Avoidable fixed OH: $1,000
Total relevant make: $6,000
$2,000 depreciation on owned equipment is unavoidable (sunk) — excluded.
Buy Option
Purchase: 50,000 × $0.11 = $5,500
Shipping: 50,000 × $0.005 = $250
Total relevant buy: $5,750
Pure cost comparison: Buy saves $250/year
Make $6,000 vs. Buy $5,750 — on accounting costs alone, outsourcing wins by a narrow margin.
Considering Opportunity Cost
Outsourcing labels frees 150 hours of barista/manager time currently spent managing the small press. That time could run profitable tasting events generating an extra $1,200/year in contribution margin.
REVISED COMPARISON (INCLUDING OPPORTUNITY COST)
Make (in-house)
Relevant make cost: $6,000
Opportunity cost: +$1,200
Total economic cost: $7,200
Buy (outsource)
Relevant buy cost: $5,750
Capture the $1,200 CM
Decision: Buy — saving $1,450 in economic terms ($7,200 − $5,750). Opportunity cost turns a $250 accounting edge into a $1,450 economic advantage.
Make-or-Buy Calculator
Pre-filled with ABC Coffee Shop cold brew label data. Compare relevant make costs (variable + avoidable fixed) vs. buy price. Toggle opportunity cost to see how freed capacity changes the recommendation.
Make (Relevant)
Variable: $5,000.00
+ Avoidable fixed: $1,000.00
$6,000.00
Buy (Relevant)
Purchase + shipping per unit
$5,750.00
Recommendation: BUY (Outsource)
Buying saves $250.00 per year on relevant costs.
Break-even purchase price (excl. opportunity): $0.095/unit + shipping
Qualitative Factors in Make-or-Buy
Beyond the numbers, key qualitative considerations can override a small quantitative cost advantage.
Quality control
Will the supplier maintain the same or better quality? What are defect risks?
Reliability & lead time
Can the supplier deliver on time? Delays, strikes, or logistics issues?
Confidentiality
Does outsourcing expose proprietary recipes, designs, or processes?
Flexibility
Can ABC change label designs quickly, or are there long lead times and MOQs?
Strategic importance
Is this component strategic to the brand? Internal control may matter more than small cost differences.
Make-or-Buy Decision Steps
- 1
Define the component and volume — units needed per period; performance requirements.
- 2
Collect cost data for the internal (make) option — split into variable, avoidable fixed, and unavoidable fixed.
- 3
Collect cost data for the external (buy) option — include all per-unit and incremental fixed costs.
- 4
Identify opportunity costs — what else could you do with freed capacity if you buy?
- 5
Compute the relevant cost for each alternative — compare total economic cost (including opportunity cost).
- 6
Assess qualitative factors — quality, reliability, strategic control.
- 7
Make the decision and monitor — if outsourcing, set up supplier performance metrics.
Break-Even Outsourcing Price
Sometimes you need to know: "What supplier price would make us indifferent between make or buy?"
ABC LABEL EXAMPLE (ignoring opportunity cost)
Total relevant make = $6,000. Avoidable fixed = $1,000. Units = 50,000. Shipping = $0.005/unit.
Break-even purchase price = (6,000 − 1,000) / 50,000 − 0.005
= $0.10 − $0.005 = $0.095/label + $0.005 shipping → indifferent between make and buy.
Common Mistakes
Using full manufacturing cost instead of relevant cost
❌ Wrong
Comparing supplier price to full cost including unavoidable fixed overhead and sunk depreciation.
✅ Right
Compare to variable + avoidable fixed only. Unavoidable costs are irrelevant — you pay them either way.
Ignoring opportunity cost of freed capacity
❌ Wrong
"Buy saves only $250 — not worth the hassle."
✅ Right
Freed barista time generates $1,200 CM from tasting events. Total economic advantage of buying = $1,450.
Key Takeaway
Make-or-buy decisions compare the relevant costs and benefits of producing internally versus outsourcing. Relevant make costs include variable production costs, avoidable fixed costs, and opportunity cost of internal capacity. Relevant buy costs include purchase price, related variable and fixed costs, and potential opportunity benefits from freeing capacity. The purely quantitative comparison must then be tempered by qualitative factors such as quality, reliability, and strategic control.
Test Your Understanding
Relevant cost comparisons, opportunity cost, and break-even pricing.
Question 1: A part costs $8 to make internally (all variable). Avoidable fixed overhead is $30,000/year. A supplier offers to sell the part for $7.50 each. Annual volume is 20,000 units. Ignoring opportunity cost, which option is cheaper?
Question 2: True or False: If a supplier's price is lower than your variable cost per unit, you should always outsource.
Question 3: ABC Coffee Shop: make cost $6,000/year, buy cost $5,750/year. Opportunity cost of making (forgone tasting events) is $1,200. What is the economic advantage of buying?
Ready to Practice?
Run make-or-buy scenarios, toggle opportunity costs, and compare outsourcing break-even prices in the Practice Lab.
Try the Practice LabWhat's Next?
Next module: Special Order Decision — applying relevant cost analysis to one-time orders at special prices, and deciding when it makes sense to accept a lower price without hurting long-term profitability.
Special Order Decision
One-time pricing with idle capacity
Relevant Costs
Future differential costs that matter