Learn how to make an informed decision on whether to make a product in-house or outsource to an external supplier.
Note: The terms business manager and production manager are used interchangeably in this blog.
There are times when a business manager must decide between alternatives that are available to the company. These alternatives can relate to making or buying a product, dropping a product line or adding a new one, and deciding whether a special order should be accepted. Below we discuss the make or buy decision.
Make or buy decision
Make or buy decision involves choosing whether to make a product in-house or purchase from an external supplier. The objective of making a choice could be to improve operational efficiency and/or cut costs.
In the process of choosing between the two alternatives, the business manager should conduct both quantitative and qualitative analysis.
Quantitative analysis
Quantitative analysis involves evaluating the numerical data of the two alternatives and determining which one cuts cost. When comparing the numerical data it is only the relevant costs that are considered (sunk costs are ignored). Relevant costs are costs that can be eliminated by choosing one alternative over the other - i.e. elimination of direct material and direct labour cost if the company decides to purchase a product from an external supplier. Sunk costs would be incurred regardless of which alternative is chosen - i.e. insurance expense for the company’s office building.
Qualitative analysis
Qualitative analysis entails doing an analysis of the different factors related to the alternatives and how those factors would impact the company. For instance, assume that rather than making the product in-house the company decides to purchase it from an external supplier. To make a decision that is most beneficial to the company, analysis of the following factors can be helpful:
- Impact on employee morale as some might fret of losing their jobs.
- Quality and reliability of the supplier’s product.
- After-sale support/warranty provided by the supplier.
- Supplier’s ability to manufacture and deliver the required quantity on time.
- Likelihood of sustaining a long-term relationship with the supplier.
Example
Assume a car manufacturing company currently manufactures cars from scratch, including all the required parts. Through close examination of the financial statements the production manager determines that of all the car parts, wheels are the most expensive to make. To cut cost the production manager approaches a wheel manufacturer who will sell wheels at a lower price. The wheel manufacturer quotes a price of $7000 for 1,000 wheels. It currently costs the company $11,000 ($4000 direct material, $5,000 direct labour and $2000 insurance expense) to make the 1,000 wheels.
Through quantitative analysis we determine that it costs $9,000 ($4000 direct material, $5,000 direct labour) to make the wheels in-house. Note that insurance expense of $2,000 is ignored since it is a sunk cost. Although, we save $2,000 (9,000 - $7,000) by choosing to buy the wheels, we should also do a qualitative analysis to ensure an informed decision is made.
For professional advice contact Alpha Accountzy, Accounting & Tax Solutions.
