Deciding Between Making or Buying: Relevant Costs Analysis

Every growing business eventually asks the same question: should we make this ourselves, or is it smarter to buy it from someone else? A garment exporter deciding whether to weave its own fabric or buy it from a mill, a bakery chain deciding whether to bake its own packaging boxes or order them from a printer, a software firm deciding whether to build its own payroll module or subscribe to one – these are all versions of the same problem. In management accounting, this is called the make-or-buy decision, and it sits squarely within the broader topic of relevant costing for decision making.

The tricky part isn’t the arithmetic. It’s figuring out which numbers actually belong in the calculation and which ones are noise left over from old accounting entries. Get that wrong, and a company can end up outsourcing a profitable operation or, worse, continuing to manufacture something that’s quietly draining its margins.

What a make-or-buy decision really involves 🔗

A make-or-buy decision evaluates whether a company should produce a component, product, or service internally using its own resources, or purchase it from an outside supplier. It’s a classic example of what accountants call a non-routine or tactical decision, alongside choices like accepting a special order, dropping a product line, or deciding whether to process a product further before selling it.

The decision usually comes up in three situations: when a company is designing a new product and must decide how to source its components, when an existing supplier raises prices and in-house production starts looking attractive again, or when a company’s own production costs creep up and buying starts to look cheaper. Whatever the trigger, the underlying question is the same – which option leaves the company financially better off, once you also weigh the things that don’t show up on a spreadsheet?

Why relevant costing is the right lens 🔗

The instinct many students and even some managers have is to compare the full cost of making something with the supplier’s quoted price. That instinct is wrong, and it’s the single biggest source of bad make-or-buy calls. Relevant costing fixes this by asking a narrower, more useful question: which cash flows will actually change if we choose one option over the other?

A cost only matters to this decision if it is a future cash flow that is caused by the decision itself. If a cost stays exactly the same whether the company makes or buys, it has no business influencing the choice.

Costs that belong in the analysis 🔗

The following costs typically change depending on which option is chosen, which makes them relevant:

• Direct materials that go into making the item, since these disappear if production stops.
• Direct labour tied specifically to making the item, provided that labour can genuinely be redeployed, laid off, or reassigned if the item is bought instead.
• Variable overheads such as power, machine consumables, or handling costs that rise and fall with output.
• Avoidable fixed overheads – the portion of fixed costs, such as a supervisor’s salary or a machine’s insurance, that would genuinely disappear if the item were no longer made in-house.
• Opportunity cost, which is the value of the next-best alternative given up. This deserves its own section below because it’s the piece most people forget.

Costs to leave out 🔗

Two categories of cost repeatedly sneak into make-or-buy calculations where they don’t belong.

The first is sunk costs – money already spent on machinery, tooling, or research that cannot be recovered regardless of what the company decides now. A machine that’s already been bought and is depreciating on the books feels important because it was expensive, but it’s identical under both options and therefore irrelevant to the choice at hand.

The second, subtler trap is unavoidable fixed overhead. Standard costing systems allocate a share of factory rent, the plant manager’s salary, and general overhead to every unit produced, which makes the “full cost per unit” of making something look inflated. But if that overhead continues regardless of whether the item is made in-house, buying it doesn’t actually save the company that money – it just shifts the same overhead onto fewer remaining units. Comparing a supplier’s price against a fully absorbed cost per unit, instead of the genuinely avoidable cost, is one of the most common reasons make-or-buy analyses go wrong.

Opportunity cost: the piece people forget 🔗

Suppose a company’s machine already runs at full capacity making Product A, but the company is weighing whether to divert some of that machine time to make a component in-house instead of buying it. If diverting the machine means giving up production of Product A, the contribution that would have been earned from those lost units of Product A is a real cost of the “make” decision, even though no cash is directly paid out for it.

This forgone benefit is what accountants call an opportunity cost – the value of the next-best alternative that’s sacrificed when one option is chosen over another. Ignore this, and “make” can look artificially cheap simply because the analysis never accounted for what else that capacity could have earned.

A simple worked example 🔗

Consider a company that currently manufactures a plastic component used in one of its products. It makes 10,000 units a year. A supplier has offered to sell the same component for ₹42 per unit.

On these numbers alone, making the component costs ₹41 against a buying price of ₹42, so continuing to manufacture in-house saves ₹1 per unit, or ₹10,000 a year across the batch. Notice what happened to the ₹7 of unavoidable fixed overhead – it was excluded from the comparison entirely, because it would be incurred either way. Had it been included, the “full cost” of making would have looked like ₹48, wrongly favouring the buy option by a wide margin.

If the freed-up capacity could instead be used to make a different product earning a contribution greater than ₹1 per unit of released capacity, the opportunity cost would tip this decision toward buying, even though the direct cost comparison favours making.

When capacity is limited, rank rather than compare 🔗

Real factories rarely make just one item, and machine time or skilled labour hours are often the true bottleneck rather than money. When a company makes several components on the same constrained resource and is weighing which ones to outsource, the right approach isn’t to compare each item’s make-versus-buy cost in isolation. Instead, the company should calculate the cost saving per unit of the scarce resource for each item and outsource the ones that free up the least valuable capacity relative to what’s saved, keeping the highest-value uses of that scarce resource in-house. This limiting-factor approach is standard practice wherever capacity, not cost alone, constrains the decision.

Beyond the numbers: qualitative factors that can override the maths 🔗

Relevant costing gives a clean, defensible number, but real make-or-buy decisions are rarely settled by arithmetic alone. Several qualitative considerations often carry as much weight as the cost comparison, particularly when the cost gap between making and buying is small.

Quality and reliability of supply 🔗

A supplier’s price is meaningless if it can’t deliver on time or to specification. India’s own automotive industry offers a useful illustration: as Maruti Suzuki scaled up production in its early years, several of its component vendors initially struggled to supply the required quantities on time, which pushed the company to get far more directly involved in developing and supporting its supplier base rather than simply outsourcing and walking away. The lesson holds for any business: an unreliable supplier can cost far more in stockouts, missed deadlines, and lost customers than any saving on paper.

Protecting proprietary processes 🔗

Some companies choose to make a component in-house purely to protect a manufacturing process, formula, or piece of intellectual property from leaking to competitors through a shared supplier. Outsourcing also creates a dependence risk: a supplier who knows it holds a critical piece of your production can raise prices later, once your in-house capability has been dismantled. The relationship between Apple and its major contract manufacturer is a well-known example of this trade-off – Apple keeps design and software in-house because these areas define its competitive edge, while manufacturing is outsourced, and it has since worked to diversify its manufacturing base, including expanding into India, specifically to reduce the risk of relying too heavily on one partner.

Strategic focus and core competence 🔗

Companies increasingly ask whether a particular activity is central to what makes them competitive. If it is, keeping it in-house preserves control and allows tighter coordination between design and production. If it isn’t, outsourcing frees up management attention, capital, and floor space for activities that actually differentiate the business in the market.

Common mistakes to avoid 🔗

A few errors show up repeatedly in student answers and real business decisions alike:

• Including unavoidable, allocated fixed overhead in the “cost to make,” which unfairly penalises the make option.
• Ignoring opportunity cost entirely when capacity is genuinely scarce.
• Treating a single year’s cost comparison as permanent, when supplier pricing, wage rates, and demand can all shift the answer within a few years.
• Reducing the decision purely to numbers and skipping quality, reliability, and strategic considerations, which can matter more than a few rupees of saving per unit.

Handled well, a make-or-buy analysis isn’t just an exam topic – it’s a genuinely useful discipline for separating cash flows that matter from the accounting noise that doesn’t, while still leaving room for judgment on the factors that numbers can’t capture.

What do you think? If you were advising a small manufacturer with idle machine capacity and a supplier offering a marginally cheaper price, would you weigh the cost saving more heavily, or the risk of losing an in-house skill the company might need again later? And how much should a supplier’s past reliability be allowed to outweigh a lower quoted price?

References

1. https://www.accaglobal.com/gb/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-articles/relevant-costs.html
2. https://costandprofitability.com/methods/make-or-buy-relevant-costs/
3. https://files.core.ac.uk/download/pdf/230430874.pdf
4. https://pressbooks.pub/supplychainmanagement3005/chapter/7-2-what-to-buy-outsourcing-decisions/