A make or buy decision involves managers choosing whether to manufacture a product in-house (make) or to purchase it (buy) from a third-party subcontractor. A make or buy decision is therefore about the relative benefits or gains of insourcing compared with those of outsourcing production.

In-house production enables the organization to have closer control over costs and quality. It also allows the business to have better overall management of the production process. However, using third party suppliers (subcontractors) can create flexibility and capacity for the business, such as dealing with unexpected fluctuations in the level of demand. Subcontractors may also be more productive and cost-effective.

There are two straightforward quantitative techniques that can be used when businesses decide whether to make or buy. These methods are called the “cost to make” and “cost to buy”. The cost to buy (CTB) refers to the total cost of subcontracting production to a third-party supplier, i.e., the cost of outsourcing production. By contrast, the cost to make (CTM) refers to the total costs of producing a good or service in-house. i.e., the cost of producing the product internally rather than outsourcing.

In general, the following rules apply based on quantitative reasoning:

• If the CTM > CTB, the firm should use outsourcing or subcontracting.

• If the CTB > CTM, the firm should use insourcing (in-house production).

The cost to buy (CTB) method calculates the total cost of subcontracting production to a third-party supplier.

For example, some of the world’s largest electronics companies subcontract production to Foxconn, located in Shenzhen, China. Foxconn is the world’s largest contract electronics manufacturer. The multinational company, headquarted in Taiwan, makes products for its corporate clients that include: Apple (iPad and iPhone), Amazon (Kindle), Nintendo (Wii U), Sony (PlayStation), and Microsoft (Xbox One).

China has provided many opportunities to use subcontractors

As a customer, the cost to buy (CTB) a product from a supplier is calculated by using the formula:

The CTB method in a make or buy decision allows a business to calculate the total cost of outsourcing production. If the cost to buy is less than the cost to make (CTB < CTM), then it makes financial sense for the firm to purchase the product from a third party provider, rather than making it in-house. It can then resell the product and earn higher profit margins.

In a make or buy decision, managers calculate the costs of making a product compared to the overall cost of buying the product from a supplier instead. The cost to make (CTM) refers to the total costs of producing a good or service in-house, rather than using a third-party supplier. The CTM a good or service in-house is calculated by using the formula:

Consider the example below:

A hotel is considering whether to make or buy 3,000 luxury cupcakes for a special function. It can make these for a variable cost per unit of $4.50 per cupcake, and would allocate $4,500 in fixed costs to this order. Alternatively, the hotel can buy the cupcakes from a reputable supplier at a price of $7.0 per cupcake, less 10% discount for the bulk order. In this particular example:

• The hotel’s CTM = $4,500 + ($4.50 × 3,000) = $18,000

• The hotel’s CTB = ($7.0 × 0.9) × 3,000 = $18,900

Hence, it is cheaper for the hotel to make the cupcakes rather than using the specialist supplier (unless it can offer a discounted price of less than $6.0).

In reality, managers consider both qualitative and quantitative factors before making a final decision to make or buy. Examples of qualitative factors include consideration of the reputation of the third-party provider, lead times for deliveries, and the capacity of employees if in-house production is preferred.

 Watch this ABC News coverage titled “Foxconn: an exclusive inside look”, which looks at the conditions that Chinese workers put up with in China, and the implications for companies such as Apple and Disney. Do multinational companies, like Apple, have the moral obligation to tackle the problems highlighted in the video?

Read about how Putting students at St. Dominic High School, Sint Maarten, have put the CTB versus CTM decision into practice by using the hyperlink here.