Question

What are the relevant costs to be identified and used in a make-or-buy decision and provide an example of each type of cost?

Answer 1

Before we need to analyse make or buy decisions , we need to consider both qualitative and quantitative analysis

Quantitative Analysis

Organizations need to weigh the short-term financial impact of outsourcing against the long term consequences.

Several factors influence make-or-buy decisions.

• Quality:
  - Will external sourcing compromise the quality of the final product?
  - Can a business enhance the quality of its products by hiring a specialist?
• Reliability:
  - Is an external supplier better equipped to deal with sudden fluctuations in production requirements?
  - Will delegating the supply of a business process make it vulnerable to supply dips?
• Control:
  - How important is a specific process, product, or component, to the core business?
  - Will giving up the control of a process make the business less flexible?
• Capacity
  - How will the organization deal with idle resources if it decides against manufacturing in-house?
  - Will outsourcing cause redundancies and how will they impact the organization?
• Competitiveness
  - How will outsourcing affect the profitability of business?
  - Is the cost of buying a component or process from outside lower than the internal production cost?
  - Can outsourcing help the business improve its competitiveness by channeling its focus to the key areas?

Quantitative analysis

1. Make-or-buy decisions must be based on the relevant cost of each option.

2. Relevant costs in make-or-buy decisions include all incremental cash flows.

3. Any cost that does not change as a result of the decision should be ignored such as depreciation and indirect fixed costs

Relevant Costs	Examples
Variable costs	Cost of labor involved in the production. Cost of material used in manufacturing. Variable production overheads such as the cost of electricity used in production.
Direct fixed costs	Rent of production facility. Salary of factory supervisor.
Opportunity cost	Rental income from machinery that is given up for manufacturing in-house.