make or buy decisions

Outsourcing is a hot topic in business right now. Outsourcing is when a company decides to purchase a product or service from another company rather than make the product or perform the service itself. Many companies outsource components or even their entire product to another manufacturer. When companies make the decision to outsource, there are a lot of considerations. In this post, we will look at the quantitative factors that should be considered when making outsourcing decisions. Don’t forget that there are many qualitative factors such as quality and customer experience that should also be considered as part of the final decision.

The quantitative factors for make or buy and outsourcing decisions are very similar to the factors considered for keep or drop decisions. Here are some factors you should consider:

1. Compare the variable costs to the outsourced price

With make or buy decisions, we will once again use a contribution margin approach. Separate variable product costs from fixed product costs. How do the variable costs of producing the product compare to the cost of purchasing the product from another company. At first glance, it may appear that the cost of the outsourced product is higher because the variable costs of making the product are lower. However, all costs should be considered.

2. Can fixed costs be reduced if production is outsourced?

Typically, fixed costs are the determining factor in outsourcing decisions. When fixed costs are avoidable, typically the company can save money by outsourcing. However, when fixed costs cannot be avoided, the company is paying to have the product made at a higher cost than the variable costs, plus it is still incurring all of the fixed costs it would have had if the product was still being made in-house. Look to see which, if any fixed costs can be reduced or eliminated.

Once you have identified the costs that cannot be eliminated, those costs are irrelevant to your decision. Remember that relevant costs are costs that differ among the alternatives. Therefore, if a fixed cost will be paid whether or not the company outsources, it is irrelevant. When calculating the current cost to make the product, add any fixed costs that can be eliminated to the variable costs identified in step 1. This total is the controllable cost. Compare this cost to the outsource cost. If the controllable cost is lower than the outsource cost, the company should consider continuing to make the product. If the controllable cost is more than the outsource cost, it might be wise to outsource.

3. Are there alternative uses for freed capacity?

Similar to keep or drop decisions, companies should look for ways to use freed capacity. If the company decides to outsource a component, will that free up space and manpower to make more units of the primary product? Additional units means additional revenue or other ways to minimize costs. For example, maybe the company is paying for a lot of overtime because of space limitations. By outsourcing a component, that frees up space and labor, allowing the company to reduce overtime. Idle capacity means costs being paid without the potential for revenue generation. Companies should look to minimize capacity that is not in use.

Final Thoughts

If there are no alternative uses for the freed capacity and fixed costs cannot be reduced, it most likely does not make sense to outsource. Outsourcing should only be used if overall costs can be reduced and if there are no qualitative factors that outweigh the cost savings.

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