Make or Buy Analysis with Examples

Make or buy analysis is a crucial tool used in procurement knowledge area in project management. In our example make or buy decision, the relevant cost we're focusing on is the revenue from banking our product. Whether we make the product or purchase it from a vendor and then go ahead and turn it around and resell it, we're going to sell it for the same price. So revenue, since this is not going to change under either alternative, is irrelevant or unavoidable costs or revenue and therefore we can exclude it. Remember, only cost or revenue that's different from each decision gets part of our analysis here. 

The type of things that would differ would be variable manufacturing costs because we could save from not producing our own product, the fixed manufacturing costs many times can be eliminated, the purchase price for purchasing it from the vendor for buying it, and then we have a new cost here called opportunity costs. That's the potential benefit that is obtained by following up alternative costs of action. The opportunity cost is a benefit that is foregone as a result of pursuing a course of action. These costs do not represent actual cash outlays.

Now, the best way to show you about opportunity cost is to actually do it in an example. So let's look at our example here, Brooks Company, manufactured 6,000 units of a component part that is used in a product and incurred the following costs for these 6,000 units. And you can see we've got direct materials, direct labor, variable overhead, and fixed overhead. Now, if we take this $80,000 and divide it by the 6,000 units, we'll get a cost per unit of $13.33. Another company has offered to sell the same component part to our company for $12 per unit. The fixed manufacturing overhead consists mainly of depreciation on the equipment used to manufacture the part and would not be reduced if the component part was purchased from the outside firm. If the component part is purchased from the outside firm, the company has the opportunity to use the factory equipment to produce another product which is estimated to have a contribution margin of $14,000. 

What that's saying is we would be freeing up our factory to produce another component part using our same factory equipment and therefore we can have an increase in a contribution margin due to that new component we'd be producing and selling at $14,000. Now, even if it didn't tell you that you were going to use that factory equipment for something else, equipment cost is a sunk cost. Let me say that again, equipment cost and appreciation expense is a sunk cost. And remember, sunk costs are irrelevant, so they do not become part of our analysis.

The main reason for this is that if we are making our own products, we have depreciation expense. But if we buy the product, we have a loss from disposal, meaning that we have equipment on the books that's not fully depreciated. And you think about book value equals cost minus accumulated depreciation. So let's say we have a piece of equipment that costs $100,000, our useful life equals five years, so therefore depreciation expense equals $100,000 divided by five or $20,000 per year. Let's say we're in year three, so after three years, we'd have $100,000 minus three times $20 or $60,000. We still have a book value of $40,000. That book value, if we can't sell the piece of equipment to anybody, we have to absorb that, and it's called a loss from disposal. 

So a loss is like an expense. And so even though under make we have depreciation expense, under buy we would have loss, both decrease that income, and therefore we could treat, we treated a sunk cost. And therefore we say unless we can sell the piece of equipment and get some money for it, well, that's an increase in revenue that is a change or a difference in decisions. So that increase in revenue from selling the piece of equipment would go under the buy alternative. But again, we don't have that here. So here we consider equipment cost or depreciation expense a sunk cost.

So what we want to do here if we can get rid of all my extraneous marks from my tablet acting weird is we're gonna take all the things that differ. So the first thing is going to be direct materials. We also have direct labor. We have the variable cost of overhead. I'm gonna put the fixed cost here still, and we're going to show you how we shouldn't be, it's not different, but I'll put here anyway. We're also going to have the purchase price. 

Under our current making, we have direct materials of $35,000. You can see that going up to the given information, $35,000. Direct labor is $15,000. Variables 10, fixed is 20. So I'm just going to copy those down here. 15, 10, and 20. If we make, we have no purchase. So if we add this all up, that's 50, 60, 70, 80. This is my annual cost if I make. Under buying, I would have no different materials. I would have no direct labor. I would have no variable cost or overhead. The $20,000 would be the same under each one. And that's why normally we eliminate this. And for your online homework systems, be careful, many of them do not want you to include any cost that does not differ. So if that's the case, then just eliminate this because all it means is both sides get to decrease by $20,000. 

It really has no impact on your decision. And then the purchase price is 6,000 units times $12 each, which would be $72,000. I add this up, I get $92,000. Now we have one more piece of information that we have to keep track of, and that is, it told us here that we have an opportunity to use the factory to produce another product which is estimated to have a contribution margin of $14,000. Now that $14,000, the way most books treat it is to put it as an opportunity cost, an opportunity cost, not revenue, an opportunity cost, meaning if you take the alternative that would not give you this additional contribution margin, this additional revenue, it's a cost to that decision. So if we decide to make our product, that's going to give us an additional $14,000 of cost, what we call opportunity costs. And easier, under here, and therefore our total cost is $94,000 versus $92,000. And you, yes, you can just really look at the maker-buy here and decide without even looking at the change in net income for our future net income. But again, many of the online systems may want you to do it this way and come up with what is the change. If you don't have to do it, don't worry about it then. But again, if you do it this way, you can't go wrong, as long as you have the right numbers. So here, I would lose $35,000 if I make. 

That's an increase if I don't have that $35,000 of costs by buying it. That's an increase in future net income. Not having the $15,000 under buy is an increase in the future. Same thing of the $10, this is a zero. That's why we say we should eliminate that row of information. Makes no difference in our decision-making. The purchase price here of $72,000, it was zero now at $72,000. That's a new cost. So that would be a decrease in any future net income. So add this up, it's $80,000 less $72,000. I'm sorry, it's not $80. Apologize. That's $35, $40, $50, $60 minus $72,000 is $12,000. So that's a decrease. So far, of $12,000 for future net income, $60,000 less than $72,000. This is the $60,000 that we're not going to incur. So we don't incur that cost. That's an increase in net income. The $72,000 would be the future purchase price for purchasing or buying the product. That's $72,000 of new cost. So $60,000 of reduction in costs minus $72,000 of incurred costs gives us still $12,000 of new costs. $14,000 of opportunity costs minus zero is a reduction of cost of $14,000. $12,000 minus $14,000 actually gives us a $2,000 increase which is the same thing you see by just looking at the difference of these two columns. And so this is a reduction of cost. 

Because our net income would increase net income by $2,000. Whoops, thinking one thing and running down another. Because if we would have an increase of $2,000, we should go ahead and buy from our vendor. Now, one last thing I just want to look at real quick here to show you is the way we treated this opportunity cost here. Again, books call this opportunity cost even though it's generating new revenue, $14,000. We treated that if we decide to make our product, continue making our product, we're gonna lose the opportunity of making that $14,000 in revenue in the future which becomes a cost for our making alternative because it becomes a cost of making the keeping to making our product. It becomes an additional cost we have to contribute under the make column. 

Technically, if you had treated as revenue, the problem is online or systems, you have to treat it under the column that wants you to treat it under. But originally, we had $80,000 here before we took $80,000. We had $92,000 just looking at here of annual cost before opportunity costs. If you had said this was revenue, this would actually reduce the $90,000 of cost and that would become $78,000. $80,000 minus $78,000 is still a $2,000 reduction in costs. It has to give you the same answer no matter which way you treat it, as long as you treat it properly as a cost or revenue. But for most online homework systems and all of the books that I've used, they want you to treat it as an opportunity cost. That's why they're calling it a cost and therefore it goes under the column of the choice or alternative that you made that forego or excluded that new revenue. And since if we make our product, we will not get that new additional $14,000 of revenue. It becomes a cost of keeping with this decision.

See also:

Sensitivity Analysis

Variance Analysis

What-if Scenario Analysis