Manufacturers often face important choices about whether to produce a component in-house or purchase it from an outside vendor. A make versus buy decision should not be based on instinct alone, because the choice can affect cost, capacity, supply chain risk, quality, delivery schedules, and long-term strategy.
Ultimately, the decision to outsource a portion of the value chain should be carefully examined and scored against qualitative and quantitative measurements. A structured review can help leadership compare the financial impact of each option while also considering whether the item is important to customer differentiation, specialized manufacturing skills, or the firm’s core competencies.
For many companies, this decision also connects to broader planning around operations, profitability, and growth. Bowers supports business owners through services such as Advisory Services, Business Strategy & Growth, and Client Accounting & Advisory Services.
Why Make Versus Buy Decisions Matter
Manufacturers often grapple with the decision to produce a component in-house or purchase from an outside vendor. This decision can influence the way a company uses its plant capacity, manages inventory, controls product quality, and responds to customer expectations.
While vertical integration has advantages – less dependency on suppliers and managed quality – there are challenges, such as capital investment and labor management. These tradeoffs should be reviewed before a company expands internal production or shifts work to contractors.
Sometimes, decisions to dismantle vertical integration are made instead of efforts to improve an inefficient manufacturing process. Making a decision based on gut feelings or opinions not supported by financial data is careless and costly.
A company may be tempted to outsource because a process appears inefficient, but that does not automatically mean outsourcing is the better answer. The manufacturing process itself may need to be evaluated, and financial data should be used to determine which option supports the business more effectively.
This is why both qualitative and quantitative factors matter. A component may appear expensive to produce internally, but the analysis should determine whether the costs are truly avoidable. At the same time, a lower outside purchase price may not capture the risk of diminished quality, unreliable deliveries, or higher inventory levels.
Vertical Integration and Operational Tradeoffs
Vertical integration can provide less dependency on suppliers and more managed quality. These advantages may be especially important when the component affects customer expectations, delivery timing, or product performance.
However, vertical integration can also create challenges. Capital investment and labor management can place pressure on the business, especially when the company must maintain equipment, staffing, and production processes for internally manufactured components.
The decision should not be reduced to one factor. A company should evaluate whether internal production is aligned with its strategy, whether the plant has capacity, whether the component is important to customer differentiation, and whether the financial data supports the choice.
Qualitative Factors in the Decision
Before calculating the cost implications of outsourcing a particular item, the company should weigh the qualitative determinants in the options. These factors help identify whether the component is strategic enough to keep inside the business.
In the 2003 book World Class Supply Management, the authors suggest that items that fit under one of the following three categories are strategic and should be internally produced:
- The item is critical to customer differentiation, such as “Made in America”
- The item requires specialized designs and manufacturing skills
- The item fits well within the firm’s core competencies
Evaluating subassemblies against these three criteria may condense the items that should be assessed for make versus buy. This can help the company avoid spending time on items that are clearly strategic and should remain internally produced.
Qualitative review is important because not all components have the same role in the business. Some parts may be ordinary inputs that can be purchased from suppliers without affecting the company’s identity or competitive position. Others may directly support the value that customers expect from the manufacturer.
When an item is critical to customer differentiation, outsourcing may affect more than cost. It may affect how customers view the company, how the product is positioned, and whether the company can continue to claim a particular manufacturing advantage.
When an item requires specialized designs and manufacturing skills, the company should consider whether an outside vendor can meet those requirements consistently. If the expertise is already inside the business, the company should carefully evaluate whether outsourcing would weaken an important capability.
When an item fits well within the firm’s core competencies, internal production may support the broader strategy of the business. Outsourcing such an item may reduce internal control over knowledge, quality, and production timing.
Strategic Items and Core Competencies
Strategic items should receive careful attention before a company considers outsourcing. A component that supports customer differentiation, specialized designs, manufacturing skills, or core competencies may be more than a simple cost line in the accounting records.
For example, an item tied to “Made in America” may support customer differentiation. If that factor matters to customers, the decision to outsource should be evaluated against both financial data and the company’s market position.
Similarly, a component that requires specialized manufacturing skills may be difficult to replace through outside vendors. Even if an outside quote appears attractive, the company should consider whether the supplier can deliver the same level of quality and reliability.
Supply Chain Risks of Outsourcing
Outsourcing introduces considerable supply chain risk, such as potentially diminished quality and reliability of deliveries. Lead times and delivery schedules must be managed.
Additionally, suppliers may not do small production runs, thereby requiring your company to maintain higher inventory levels. These risks would need to be mitigated before committing production to contractors.
Supply chain risk should be reviewed before a company commits to an outside vendor. A lower purchase price may not be enough if the supplier cannot meet delivery expectations, quality standards, or production flexibility needs.
Manufacturers should consider how an outside vendor would affect the timing of production. If lead times increase or delivery schedules become less reliable, the company may need to adjust its own planning, inventory, and customer commitments.
Higher inventory levels can also affect the decision. If a supplier will not perform small production runs, the manufacturer may need to buy and hold more stock than it would if the component were made internally. This can affect inventory carrying costs and working capital.
Quality is another key consideration. When production is outsourced, the company may have less direct control over the process. That does not automatically make outsourcing a poor choice, but the risk should be identified and managed before production is committed to contractors.
Lead Times, Delivery Schedules, and Inventory
Lead times and delivery schedules must be managed when production is outsourced. The manufacturer should understand how supplier timing will affect production schedules and customer delivery expectations.
If the supplier cannot support small production runs, the manufacturer may need to maintain higher inventory levels. This can reduce flexibility and may create additional costs that should be considered in the analysis.
Before committing production to contractors, the company should identify how these risks would be mitigated. The decision should include practical considerations about quality control, reliability of deliveries, and inventory management.
Quantitative Factors in the Decision
The biggest challenge to solving the quantitative equation is knowing what it costs to produce the item. Using the fully loaded cost is a mistake and inflates the internal cost of production for this analysis.
Only those costs that are incremental should be considered. This distinction is important because some costs will continue whether the company makes the part internally or purchases it from an outside vendor.
Incremental costs would not be incurred if the part were purchased from an outside source. Total costs minus costs that are not avoidable represent the incremental costs of producing the subassemblies.
Incremental production costs would almost certainly include direct material and freight. Direct and indirect labor, a portion of variable overhead such as inventory carrying costs, and administrative expenses may be included.
However, these costs would likely be incurred regardless. Therefore, unavoidable costs should not be considered as a cost of the subassembly for a make versus buy analysis.
This is where a careful financial review becomes essential. If the analysis includes costs that will not actually disappear when the item is outsourced, the internal cost of production may look higher than it truly is.
A fully loaded cost can be useful for some purposes, but it can distort a make versus buy decision. The better question is which costs will change as a direct result of the decision.
For companies that need support reviewing accounting data, cost structure, or management reports, services such as Accounting Services and CFO Services can help connect operational decisions with financial information.
Incremental Costs Versus Fully Loaded Costs
Using the fully loaded cost is a mistake because it can inflate the internal cost of production. In a make versus buy analysis, the company should focus on the costs that would be avoided if the part were purchased from an outside source.
Incremental costs may include direct material and freight. They may also include direct and indirect labor, a portion of variable overhead, and administrative expenses if those costs would actually be avoided.
If those costs would likely be incurred regardless, they should not be treated as costs of the subassembly for this decision. The analysis should separate avoidable costs from unavoidable costs.
Fixed Costs and Idle Capacity
Additionally, under conditions of sufficient idle capacity, fixed costs are not incremental and should not be considered part of the cost to make the part. This is another reason why the analysis should not rely only on fully loaded internal costs.
Similarly, the purchase price, delivery costs, and incremental indirect costs should be included as costs on the purchase side of the equation. Both sides of the analysis should include only the relevant costs for the decision.
If the plant has idle capacity, manufacturing a component internally may not create additional fixed costs. If those fixed costs will remain whether the item is made or purchased, including them can distort the result.
Capacity and Multi-Part Manufacturing Decisions
A deeper analysis is required if the factory is operating at full capacity. Selecting the optimal components to manufacture will free up the capacity to produce items that would be more expensive to buy on the outside.
When capacity is limited, the decision is not only whether a single item should be made or purchased. The company must determine how to use limited labor hours and machine hours in the most effective way.
If multiple parts are being manufactured, follow this step-by-step analysis:
- Determine the capacity of the plant in terms of labor hours and machine hours
- Calculate the incremental cost to produce versus purchase for each item under consideration
- Choose to produce the items with the greatest incremental savings over purchase until plant capacity is filled; outsource the remaining
This method helps the company focus internal production on the items that produce the greatest incremental savings. It also helps avoid filling plant capacity with components that could be purchased more efficiently from the outside.
When a factory is operating at full capacity, every hour of labor or machine time has an opportunity cost. Producing one component internally may prevent the company from producing another component that would save more money compared with outside purchasing.
The step-by-step analysis creates a more disciplined way to allocate limited resources. It also helps management compare multiple components using a consistent framework instead of relying on opinions or incomplete cost data.
Labor Hours and Machine Hours
Plant capacity should be determined in terms of labor hours and machine hours. These measures help the company understand the practical limits of internal production.
Once capacity is known, the company can calculate the incremental cost to produce versus purchase for each item under consideration. This comparison should be made before deciding which items remain in-house and which are outsourced.
The company should choose to produce the items with the greatest incremental savings over purchase until plant capacity is filled. The remaining items can then be outsourced based on the analysis.
Develop a Decision Tree
A decision tree can help organize the make versus buy analysis. It can bring together the qualitative and quantitative considerations that affect whether a component should be manufactured in-house or purchased externally.
Create a decision tree and include the following considerations:
Favor Manufacturing In-House
Manufacturing in-house may be favored when internal production supports cost, capacity, control, and supply considerations. The decision tree should include these factors:
- Less expensive to make the part
- Use of excess plant capacity
- Control over quality
- Control of lead time
- Greater assurance of continual supply
These factors may support internal production when the company has available capacity and when control over quality, lead time, and supply is important. Internal production may also be preferred when the incremental cost to make the part is lower than the cost to purchase it.
Use of excess plant capacity can be an important factor. If labor hours and machine hours are available, producing internally may allow the company to use existing resources more effectively.
Favor Purchasing Externally
Purchasing externally may be favored when the supplier offers an advantage in quality, cost, or capacity. It may also be appropriate when the item is not essential to the firm’s strategy.
- Higher quality from the supplier
- Less expensive
- Insufficient capacity
- Item not essential to the firm’s strategy
These factors may support outsourcing when the supplier can provide higher quality or lower cost, or when the manufacturer does not have sufficient internal capacity. The decision may also be easier when the item is not essential to the firm’s strategy.
The decision tree should not replace financial analysis, but it can help management organize the factors that matter. It can also help multiple disciplines within the organization contribute insight before a final decision is made.
Concluding the Make Versus Buy Analysis
Conclude your decisions after multiple disciplines within the organization have contributed their insight and only after empirical data supports the direction of outsourcing. This final step helps ensure the decision reflects both operational realities and financial evidence.
A make versus buy analysis should include input from the people who understand production, quality, purchasing, finance, inventory, and customer expectations. Each discipline may see a different part of the decision, and those insights can help create a more complete evaluation.
The final decision should not be based on gut feelings or unsupported opinions. It should be supported by financial data, supply chain review, capacity analysis, and a clear understanding of the company’s strategy.
Outsourcing may be the right choice when it lowers relevant costs, improves quality, addresses insufficient capacity, or involves an item that is not essential to the firm’s strategy. Internal production may be the right choice when the item is strategic, less expensive to make, uses excess plant capacity, or requires stronger control over quality, lead time, and continual supply.
The key is to compare the options carefully. A disciplined process can help manufacturers avoid careless and costly decisions while focusing internal resources where they create the most value.
FAQ
These frequently asked questions summarize the main points manufacturers should consider when deciding whether to make a component in-house or buy it from an outside vendor.
What is a make versus buy decision?
A make versus buy decision is the process of deciding whether to produce a component in-house or purchase it from an outside vendor. The decision should be examined and scored against qualitative and quantitative measurements.
Why should manufacturers avoid using gut feelings?
Making a decision based on gut feelings or opinions not supported by financial data is careless and costly. The analysis should be supported by empirical data and input from multiple disciplines within the organization.
Which items should usually be produced internally?
Items that are critical to customer differentiation, require specialized designs and manufacturing skills, or fit well within the firm’s core competencies are strategic and should be internally produced.
What risks can outsourcing introduce?
Outsourcing introduces supply chain risk, including potentially diminished quality and reliability of deliveries. Lead times and delivery schedules must be managed, and suppliers may require higher inventory levels if they do not do small production runs.
What costs should be included in the analysis?
Only incremental costs should be considered. Incremental costs are costs that would not be incurred if the part were purchased from an outside source. Unavoidable costs should not be considered as a cost of the subassembly for a make versus buy analysis.
What changes when the factory is at full capacity?
A deeper analysis is required when the factory is operating at full capacity. The company should determine plant capacity, calculate the incremental cost to produce versus purchase for each item, and produce the items with the greatest incremental savings until plant capacity is filled.