What a make or buy decision is
A make or buy decision compares producing an item in-house with purchasing it from a supplier. The right answer comes from the relevant cost of each option at the expected volume, not from the fully absorbed unit cost, and is then checked against what the numbers cannot show: quality, lead time, risk and strategy.
The calculation starts from the production cost of the part, but separates what changes with the decision from what stays regardless. That separation is where most analyses go wrong.
Make or buy visual map
The map shows the two cost lines, the indifference point and the worked example at 6,000 parts per month.
The indifference point formula
Making has an avoidable fixed cost (F) plus a variable cost per part (v). Buying has only the purchase price per part (p). The two costs are equal at volume Q*:
F + v × Q* = p × Q* ⇒ Q* = F ÷ (p − v)
Below Q*, buying is cheaper. Above it, making is cheaper. This is the same logic as the break-even point, applied to two alternatives instead of revenue against cost.
Worked example: a machined bracket
Fictional example. A plant buys a machined bracket at $15.50 each. Making it would require a fixture and a dedicated programmer totaling $24,000 per month of avoidable fixed cost, plus $11.50 of variable cost per part (material, direct labor, energy and consumed tooling).
Q* = 24,000 ÷ (15.50 − 11.50) = 24,000 ÷ 4.00 = 6,000 parts per month
| Volume (parts/month) | Make ($) | Buy ($) | Saving from making ($) | Decision |
|---|---|---|---|---|
| 2,000 | 47,000 | 31,000 | −16,000 | Buy |
| 4,000 | 70,000 | 62,000 | −8,000 | Buy |
| 6,000 | 93,000 | 93,000 | 0 | Indifferent |
| 8,000 | 116,000 | 124,000 | +8,000 | Make |
| 10,000 | 139,000 | 155,000 | +16,000 | Make |
Check at 8,000 parts: making costs 24,000 + 11.50 × 8,000 = $116,000; buying costs 15.50 × 8,000 = $124,000. The $8,000 monthly gap is $1.00 per part (unit cost of $14.50 versus $15.50).
At 4,000 parts the picture flips: making costs $70,000 and buying $62,000. Making only pays off if stable demand stays above 6,000.
Which costs belong in the calculation
- Include: costs that disappear if you buy, such as material, direct labor, energy, tooling and dedicated supervision.
- Exclude: costs that remain if you buy, such as building rent, depreciation of equipment already paid for and allocated overhead.
- Opportunity cost: if the freed capacity has another use, include the margin you would lose. With idle capacity and no alternative use, only variable cost counts, and making almost always wins.
- Costs of buying: freight, safety stock, incoming inspection and supplier management belong in the effective purchase price.
If the investment is new (a machine or fixture), bring the fixed cost to a monthly figure with NPV, IRR and payback instead of allocating it arbitrarily.
Factors the numbers do not show
| Factor | Favors making when | Favors buying when |
|---|---|---|
| Quality and secrecy | The process is a differentiator or confidential | A specialist supplier has better process capability |
| Lead time | You need fast, flexible response | The supplier delivers reliably with short lead time |
| Capacity | Your plant has spare capacity | Your capacity is at its limit or at the bottleneck |
| Risk | The supplier is single-source and unstable | Several qualified suppliers exist |
| Strategy | The item is a core competence | The item is a commodity outside your business |
Before outsourcing, check the supplier's cost of quality and the real delivery lead time. If your plant is at its limit, look at the capacity calculation too: sometimes the answer is to buy only the overflow.
Step-by-step decision process
- Define expected annual volume and its uncertainty (low, likely, high).
- Gather the effective purchase price, including freight, packaging and inspection.
- List the fixed and variable costs that change with the decision.
- Calculate Q* and compare it with expected volume.
- Test scenarios: demand 20% lower, supplier price increase, exchange rate.
- Weigh the qualitative factors and decide, recording the assumptions.
A middle path is to make up to your capacity and buy the excess, or to keep two purchase sources to reduce risk.
Common mistakes
- Comparing the fully absorbed cost (including costs that do not vanish when buying) against the supplier's price.
- Ignoring the opportunity cost of capacity and capital.
- Deciding on today's volume without testing demand variation.
- Forgetting hidden costs of buying: logistics, rework, delays and contract management.
- Outsourcing a core competence and losing the ability to recover it.
- Treating the decision as permanent instead of reviewing it when price or volume changes.
Frequently asked questions
What is a make or buy decision?
It is the choice between producing an item in-house or purchasing it from a supplier, based on relevant costs and risks.
What is the indifference point formula?
Q* = F ÷ (p − v), where F is the avoidable fixed cost of making, p the purchase price and v the variable cost of making.
What is Q* in the example?
24,000 ÷ (15.50 − 11.50) = 6,000 parts per month. Above that, making is cheaper.
Should I include allocated overhead?
Only the portion that disappears if you buy. Costs that remain in either scenario are not part of the decision.
Is make or buy the same as outsourcing?
Outsourcing is one possible outcome. Make or buy is the analysis that tells you whether outsourcing or insourcing pays off.
Does it pay to make when capacity is idle?
Usually yes, if the capacity has no alternative use: only variable cost matters. If it does, include the margin you would give up.
Sources
- SLACK, N.; BRANDON-JONES, A.; JOHNSTON, R. Operations Management. Pearson.
- HORNGREN, C. T.; DATAR, S. M.; RAJAN, M. Cost Accounting: A Managerial Emphasis. Pearson.
- HEIZER, J.; RENDER, B. Operations Management. Pearson.
Keep studying: trusted sources and links
- Sebrae: gestão, custos e finanças para empresas (in Portuguese)
- CFC: Conselho Federal de Contabilidade (in Portuguese)
Save this address: Manufatura Enxuta is your school for lean manufacturing. Come back whenever you need to study, with a complete article, a visual map and trusted sources. Follow one of the learning paths or check the A–Z glossary.
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About the author
Lean Manufacturing & Behavioral Management Specialist
Over 20 years in the automotive and metalworking industries (GM and Dana), Lean Manufacturing practitioner since 2006. SENAI instructor and mentor in Brazil’s Brasil Mais Produtivo program, delivering consulting, training and audits for 50+ companies, combining quality, productivity and people development.
