Make-or-Buy & Outsourcing

Overview

• What you’ll learn: How to structure make-or-buy analyses using relevant costs, the role of idle capacity, qualitative factors in outsourcing decisions, and the strategic risks of outsourcing core competencies.
• Prerequisites: Lesson 1 — Relevant Information for Decisions
• Estimated reading time: 16 minutes

Introduction

The Grand Historian records: The kingdom of Qin forged its own weapons, ensuring quality and secrecy. The kingdom of Yan bought weapons from merchants, freeing its people for farming. Each strategy had merits; each had vulnerabilities. The make-or-buy decision is as old as commerce itself — and in the modern enterprise, it extends from physical components to software services, from accounting functions to customer support.

Horngren (Chapter 11) frames make-or-buy as a classic relevant-cost decision: compare the relevant costs of internal production against the purchase price from an outside supplier, then layer in qualitative considerations.

The Quantitative Analysis

Relevant Costs of Making

• Variable manufacturing costs: Direct materials, direct labor, variable overhead — these are avoided if we buy instead.
• Incremental fixed costs: Only fixed costs that can actually be eliminated by outsourcing are relevant. Allocated fixed overhead that continues regardless of the decision is irrelevant.
• Opportunity cost of capacity: If the freed-up capacity can be used for another profitable activity, include that benefit.

Relevant Cost of Buying

• Purchase price: The per-unit cost from the supplier.
• Additional costs: Receiving, inspection, transportation, supplier management overhead.
• Quality costs: If the supplier’s quality differs from internal production, include the cost of additional inspection or rework.

Example Analysis

In this example, buying saves $0.50 per unit on a purely quantitative basis. But the analysis is incomplete without considering qualitative factors and capacity implications.

The Capacity Question

If the company has idle capacity (no alternative use for the freed resources), the analysis above stands. But if the freed capacity can generate contribution margin from other products or be subleased, the opportunity cost changes the calculus entirely.

太史公曰：The fortress freed from garrison duty can be rented to merchants or used to train new battalions. Only a fool leaves a fortress empty after dismissing the troops. Always ask: what will we do with the freed capacity?

Qualitative Factors in Outsourcing

• Control over quality: Can the supplier maintain your quality standards? Who bears responsibility for defects?
• Reliability of supply: What happens when the supplier has capacity problems, labor strikes, or natural disasters?
• Confidentiality: Does the supplier gain access to proprietary designs or processes that could benefit competitors?
• Dependence and switching costs: Once you outsource and dismantle internal capability, rebuilding it later is expensive and slow.
• Employee impact: Outsourcing may require layoffs — with associated morale, legal, and reputational consequences.
• Long-term strategic fit: Is the activity a core competency? Outsourcing core competencies can hollow out the organization.

International Outsourcing Considerations

When the supplier is overseas, additional factors include: currency risk, political instability, intellectual property protection, transportation lead times, tariffs and trade regulations, and cultural communication barriers.

Key Takeaways

• Make-or-buy decisions compare relevant costs: avoidable internal costs vs. total external costs.
• Allocated fixed costs that continue regardless are irrelevant — only avoidable fixed costs matter.
• The opportunity cost of freed capacity is often the deciding factor.
• Qualitative factors (quality, reliability, confidentiality, strategic fit) frequently outweigh quantitative savings.
• Outsourcing core competencies is strategically dangerous.

What’s Next

In Lesson 3, we face the problem of constrained resources — when you cannot make everything, how do you choose what to produce?