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The decision to make or buy

If you are not involved in a manufacturing environment, you may be tempted

to skip this section on the grounds that make or buy decisions will be irrelevant to you. Nothing could be further from the truth! This we will demonstrate in the next section, which is concerned with the evaluation of providing internal services against the use of outside contractors, and represents a good illustration of an application of make or buy principles.

Stated very simply, in a make or buy decision, buying is preferable on economic grounds when the relevant costs for making are greater than the price quoted by the supplier. As with many decisions, what often confuses the analysis is the distinction between those costs that are relevant to making the decision and those that are not. The distinction between relevant and non–relevant costs for make or buy decisions is exactly the same as described earlier insofar as relevant costs are future orientated and differential. However, to aid your understanding of their applications to make or buy decisions we will relate it to the following example.

The purchasing manager of T.O. Wood Ltd has been investigating the possibility of buying a certain component from an outside supplier. L. Driver Ltd is prepared to sign a one year contract to deliver 10,000 top quality units as needed during the year at a price of £5.00 per unit. This price of £5.00 is lower than the estimated manufacturing cost per component of £6.00, which is made up as follows:

Table 1 Product cost statement

    Unit cost £
Direct material costs   1.20
Direct labour costs   1.80
Factory variable cost   0.60
Annual machine rental   0.40
Factory fixed cost - Allocated 0.50
  - Apportioned £1.50

It appears at first sight that it will make better economic sense to buy rather than to make, however, let us consider whether all of the items within the product cost breakdown are relevant, i.e. ‘If the decision is made to buy, which of the costs will be avoided?’ An investigation of the components reveals that direct materials, direct labour, factory variable costs, annual machine rental and factory fixed costs – allocated would all be avoided. As the total of these relevant costs amounts to £4.50, which is less than the price of £5.00 quoted by the supplier, the decision should be to continue making the component. The remaining £1.50 of costs relating to apportioned fixed costs would presumably have to be borne elsewhere in the company and because they do not differ, irrespective of the course of action, are irrelevant.

Even if the analysis had indicated it to be more desirable to buy on economic grounds, there would still be factors to be considered other than the purely financial ones. For example, loss of know-how in producing this component, the loss of certain skilled labour, not being able to control future cost increases and, therefore, final product prices, the ability to fill up capacity in slack times, and the possibility of finding it difficult to obtain supplies at a reasonable price during boom times, which must all be taken into consideration.

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