Building the Part Yourself Seems Cheaper Than It Really Is
The make or buy decision is one of the most common analyses in corporate finance and one of the easiest to get wrong, because the obvious cost comparison uses the wrong costs.
The Question
A company needs a component, a service or a capability. It can produce it internally or purchase it from an outside supplier. The make or buy analysis compares the two, and it appears everywhere from manufacturing components to payroll processing to data centres.
It looks like a straightforward cost comparison. It is not, because the internal cost figure that accounting produces is usually not the cost that is relevant to the decision.
The Standard Mistake
Internal product costing typically includes allocated fixed overhead. The reported cost to make a part might be 9 dollars, built from 5 of materials, 2 of direct labour and 2 of allocated factory overhead. A supplier quotes 12. Making it appears to save 3 dollars per unit.
Now ask what happens if the company buys instead. Materials cost disappears. Direct labour may disappear, depending on whether those workers are redeployed or released. The 2 dollars of allocated overhead almost certainly does not, because the factory roof, the plant manager and the depreciation on shared equipment continue regardless.
| Cost element | Make | Avoided if buying |
|---|---|---|
| Materials | 5.00 | Yes |
| Direct labour | 2.00 | Only if genuinely released |
| Allocated overhead | 2.00 | No |
| Relevant total | 7.00 | Compare against 12.00 |
The comparison is never internal cost against supplier price. It is avoidable internal cost against supplier price, and allocated overhead is rarely avoidable.
In this example the relevant internal cost is 7, not 9, so making is better by 5 dollars rather than 3. The error can run in either direction, and when a company outsources on a comparison that included unavoidable overhead, it discovers afterwards that total costs went up.
The Capacity Question
The analysis changes completely depending on whether the production capacity has an alternative use.
If the line would otherwise sit idle, the relevant cost is the incremental cost only, as above. If the same capacity could produce something else profitable, that forgone profit is an opportunity cost and belongs in the comparison. A line that could produce a product earning 40,000 dollars of contribution is not free just because the equipment is already owned.
This is where make or buy stops being an accounting exercise and becomes a capacity allocation question, which is usually the more important one.
What the Spreadsheet Leaves Out
Several consequential factors do not appear as line items.
Supplier dependence. Once internal capability is dismantled, the company loses its outside option. A supplier that knows this has pricing power at renewal that it did not have at first quote. The low initial price is sometimes an investment by the supplier in exactly that position.
Knowledge loss. Manufacturing a component teaches an organisation things about the product. Companies that outsourced production have repeatedly found that design capability atrophied alongside it, because the two were less separable than the org chart suggested.
Quality and responsiveness. Internal production can be redirected on short notice. A supplier serving many customers cannot always accommodate an urgent change, and contractual remedies compensate for a failure rather than preventing it.
Coordination cost. Managing a supplier requires procurement staff, quality auditing, contract negotiation and dispute handling. This is real spending that rarely appears in the buy column of the initial comparison.
The Strategic Filter
Before the numbers, a simpler question is often decisive: is this capability part of what makes the company distinctive. Activities that differentiate the product are usually kept internal even at higher cost, because control over them is the point. Activities that are necessary but generic are natural candidates to buy, since a specialist supplier operating at scale can genuinely do them cheaper.
Getting this backwards, outsourcing the distinctive thing because a spreadsheet said it was cheaper, is the version of this mistake that does lasting damage.
The Bottom Line
Make or buy is a decision about avoidable costs, opportunity costs and strategic control, in that order of frequency of error. Compare only the costs that genuinely change, include the profit forgone from any alternative use of the capacity, and add the coordination cost of managing a supplier that the initial quote never mentions. Then ask whether the capability is one the company should own regardless of what the arithmetic says.