Welcome to the Make or Buy Decision!

Have you ever debated whether it’s cheaper to cook a fancy dinner at home or just order takeout? If so, you’ve already mastered the basics of a Make or Buy decision!

In Management Accounting, businesses face this exact choice every day. Should they manufacture a component in their own factory (Make), or should they pay an external supplier to provide it (Buy)? This chapter is a crucial part of Section D: Decision-making in your BA2 syllabus. We are going to learn how to strip away the "noise" and focus only on the costs that actually matter.

1. What is a Make or Buy Decision?

At its heart, a Make or Buy decision (also known as an outsourcing decision) is about choosing the most cost-effective way to obtain the goods or services a business needs.

Don't worry if this seems tricky at first. The "secret sauce" to getting these questions right is understanding Relevant Costs. We only care about costs that will change because of our decision.

The Everyday Analogy

Imagine you own a bakery. You need bread boxes.
- Make: You buy cardboard, hire a part-time worker, and use a folding machine you already own.
- Buy: You pay a local packaging company \$2 per box.\n

\nWhich is better? To decide, you shouldn't look at your shop's total rent (you pay that anyway!). You should only look at the extra money you spend to make the boxes yourself.\n

\n\n

2. Relevant Costs: What Counts?

\n

\nWhen comparing the two options, we only look at incremental costs—the extra cash flowing out of the business. \n

\n\n
Costs to "MAKE":
\n

\n1. Variable Production Costs: This includes Direct Materials, Direct Labour, and Variable Overheads. If you don't make the product, you don't spend this money.\n
\n2. Specific Fixed Costs: These are fixed costs that only exist if you manufacture the item. For example, if you have to rent a special machine just for this part, that rent is relevant. \n
\n3. Opportunity Costs: This is a "hidden" cost. If making the part uses up factory space that you could have rented out to someone else for \$1,000, then that \$1,000 is a "cost" of making.\n

\n\n
Costs to "BUY":
\n

\n1. Purchase Price: The invoice price from the supplier.\n
\n2. Inward Freight/Delivery: Any extra shipping costs you pay to get the items to your warehouse.\n

\n\n

Quick Review: What to IGNORE

\n

\n- Sunk Costs: Money already spent (like R&D from last year).\n
\n- Depreciation: Usually a non-cash accounting entry, so ignore it unless it represents a change in resale value.\n
\n- General Allocated Overheads: Things like "Head Office Rent" or "Manager's Salary" that stay the same regardless of what you decide.\n

\n\n

3. The Step-by-Step Calculation

\n

\nTo make the right choice, follow this simple logic:\n

\nStep 1: Calculate the Relevant Cost to Make.\n
\n\( \text{Relevant Cost to Make} = \text{Variable Costs} + \text{Specific Fixed Costs} + \text{Opportunity Costs} \)\n

\nStep 2: Identify the Relevant Cost to Buy.\n
\n\( \text{Relevant Cost to Buy} = \text{Purchase Price per unit} \times \text{Quantity} \)\n

\nStep 3: Compare. Choose the cheaper option!\n

\n\n
Example Walkthrough:
\n

\nCompany X needs 10,000 units of Component Z.\n
\n- To Buy: It costs \$12 per unit.
- To Make:
--- Direct Materials: \$5\n
\n--- Direct Labour: \$4
--- Variable Overheads: \$1\n
\n--- Allocated Fixed Overheads: \$3 (Ignore this! It's not incremental.)
--- Special Machine Hire: \$5,000 total.\n

\nCost to Buy: \( 10,000 \times \$12 = \$120,000 \)\n
\nCost to Make: \( 10,000 \times (\$5 + \$4 + \$1) + \$5,000 = \$105,000 \)

Decision: Make the component! You save \$15,000.

4. Qualitative Factors (The Non-Financial Stuff)

Wait! Before you sign the contract, remember that numbers don't tell the whole story. In your CIMA exam, you might be asked why a company might choose the more expensive option.

  • Quality: Can the supplier be trusted to maintain the same quality as you?
  • Reliability: What if the supplier goes on strike or has delivery delays? Your whole production line could stop!
  • Flexibility: Can the supplier handle a sudden rush order?
  • Intellectual Property: If you "buy," are you giving away your trade secrets to an outsider?
  • Staff Morale: If you "buy" instead of "make," will you have to fire your workers? This could hurt the company’s reputation.

Key Takeaway: A decision is rarely based on cost alone. The cheapest option isn't always the best for the long-term health of the business.

5. Common Mistakes to Avoid

1. The "Total Cost" Trap: Students often include fixed overheads that the business would pay anyway. Remember: If the cost doesn't change because of your choice, it is irrelevant.

2. Ignoring Opportunity Costs: If the question says "the machine could be used for another project instead," that other project's lost profit is a cost of making.

3. Per Unit vs. Total: Be careful with Fixed Costs. They are usually given as a Total, while Variable Costs are given Per Unit. Make sure you convert them to the same scale before adding!

6. Summary Quick-Check

Did you know? Outsourcing is just another name for a "Buy" decision. Companies like Apple "buy" the assembly of iPhones from Foxconn rather than "making" them themselves!

- Make: Focus on Variable Costs + Specific (incremental) Fixed Costs.
- Buy: Focus on Purchase Price + Delivery.
- Relevant Costs: Only future cash flows that differ between the options.
- Qualitative: Don't forget quality, reliability, and employee impact.

Keep practicing these calculations! Once you get used to filtering out the "irrelevant" information in a question, you'll find Make or Buy decisions are one of the most logical parts of your BA2 studies.