This lesson applies the principles of relevant costing to the make-or-buy decision, a common short-term decision. It covers the analysis of whether to produce a product or service internally or outsource it to an external supplier, considering both quantitative and qualitative factors.

• Definition and Purpose: A make-or-buy decision involves evaluating whether a company should manufacture a product or component internally or purchase it from an outside supplier. This is also known as an outsourcing decision. This differential decision-making tool is also used to analyze performing any activity internally versus outsourcing the activity to an outside supplier, such as payroll and customer service.

• The Relevant Cost Analysis:

  • Relevant Costs: The costs that will differ between the “make” and “buy” alternatives. This typically includes direct materials, direct labour, variable overhead, and any avoidable fixed costs associated with internal production. The purchase price from the external supplier is also a relevant cost.

  • Irrelevant Costs: Sunk costs, such as the original cost of equipment, and unavoidable fixed costs that will continue regardless of the decision, are irrelevant. If fixed costs would not be eliminated by outsourcing, they are not relevant.

• Example: A company that currently manufactures a part must decide whether to continue or purchase it for $15 per unit. If the variable costs of manufacturing are $13 per unit and the fixed costs are unavoidable, the company should outsource because the $15 purchase price is greater than the $13 variable cost saved. The fixed costs would be incurred regardless. If the fixed costs are avoidable, they must be included in the analysis.

• Qualitative Factors: In addition to the quantitative analysis, qualitative factors must be considered. These include the reliability of the supplier, the quality of the purchased product, the risk of supply disruptions, the impact on employees, and the strategic importance of maintaining in-house capabilities. For instance, outsourcing a core competency may create long-term risks.