What is a Make or Buy Analysis?

The make or buy decision involves whether to manufacture a product in-house or to purchase it from a third party. The outcome of this analysis should be a decision that maximizes the long-term financial outcome for a company. This analysis is typically conducted when a business finds that its in-house production capacity is constrained, or when it is having problems sourcing goods from suppliers, or when it is experiencing significant changes in the demand for its products.

What Factors Impact a Make or Buy Analysis?

There are a number of factors to consider when making a make or buy decision, including the cost of the item, the required capacity, and required funding. These issues (and more) are addressed below:

Cost of the item. Which alternative presents the lowest total out-of-pocket cost? Businesses tend to include fixed costs when adding up their internal costs, which is incorrect. Only direct costs should be included in the compilation of the internal cost to manufacture a product in-house. This amount should be compared to the quoted price of a supplier.
Required capacity. Will the company have sufficient capacity to produce the product in-house? Alternatively, is the supplier reliable enough to be able to produce the goods in sufficient quantities and in a timely manner? If the company is a relatively minor customer, it is possible that it will receive minimal deliveries from the supplier during high-demand periods.
Required expertise. Does the company have sufficient expertise to make the goods in-house? In some cases, a business has experienced such a high rate of product failure that it has no choice but to outsource the work to a supplier. In this case, the real debate is whether there is any chance of being able to enhance the in-house production capability.
Required funding. Does the company have enough cash to purchase the equipment needed for in-house production? If the equipment is already on site, could outsourcing the work allow the equipment to be sold, so that the cash can be used elsewhere? This is a major concern for startup companies, which have little excess cash available to invest in facilities.
Impact on company bottleneck. Will shifting production to a supplier ease the burden on the company's bottleneck operation? If so, this can be an excellent reason to buy the goods. If the bottleneck is elsewhere (such as in the sales department), then this is not a consideration.
Availability of drop shipping. A supplier may offer to store the goods at its facility and then ship them directly to the company's customers as they place orders. This approach shifts the burden of investing in inventory to the supplier, which can represent a substantial reduction in working capital. However, doing so also gives the supplier the names and addresses of the company’s customers.
Strategic importance. How important is the product to the corporate strategy? If it is very important, then it could make more sense to manufacture the product, in order to maintain complete control over it. This option is most likely to be taken if the company has proprietary production technology that it does not want to share with a supplier. Conversely, something having little importance can more easily be shifted to a supplier.

It might initially appear that a make or buy analysis is a quantitative one that involves a simple comparison of internal production costs to a supplier's quoted price. However, the preceding points should make it clear that the make or buy decision actually encompasses a large number of qualitative issues that may completely override a numerical analysis of production costs.