Decision Making - Make or Buy

Question 1

What considerations should be taken in make or buy decisions (insourcing vs. outsourcing)?

Answer 1

The firm should use available resources as efficiently as possible before outsourcing. Often, an array of products can be produced efficiently if production capacity is available

If not enough capacity is available to produce all products, those that are produced least efficiently should be outsourced (or capacity should be expanded)

Support services (i.e. computer processing, legal work, accounting and training) may also be outsourced

Also, both products and services may be outsourced internationally. Thus, computer programming, information processing, customer service via telephone, etc., as well as manufacturing may be not only outsourced, but outsourced offshore

Question 2

What kinds of costs are considered in make vs. buy decisions?

Answer 2

As with special order, the manager considers only the costs relevant to the investment decision:

1. The key variable is total relevant costs (not all costs)
2. Sunk costs are irrelevant. Hence, a production plant’s cost of repairs last year is irrelevant to this year’s make-or-buy decision. The carrying amount of old equipment is another example
3. Costs that do NOT differ between two alternatives should be ignored because they are not relevant to the decision being made
4. Opportunity costs must be considered when idle capacity is not available. They are of primary importance because they represent the forgone opportunities of the firm

Note: If the total relevant costs of production are LESS than the cost to buy the item, it should be insourced. Also, the firm should consider the qualitative aspects of the decision. For example, will product quality be as high if a component is outsourced than if produced internally? How reliable are the suppliers?