Impact of Relevant Costs on Make-or-Buy Decisions

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  • 0:00 Make or Buy?
  • 0:45 Calculating Relevant Costs
  • 1:25 Considering…
  • 2:25 Example
  • 3:22 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Companies are often faced with many decisions, and a reoccurring one is whether it is better to make or buy certain goods or services. This lesson provides details on the impacts of such decisions.

Make or Buy?

There is an incredible amount of overlap between companies. While each business does something different, many of them have the same needs. There are always accounting, advertising, and administrative duties that need to be performed, and those are just the ones that start with the letter 'A'!

As a result, many companies choose to buy these services instead of hosting or even making them in house. The process of hiring someone else to do a task that the company would otherwise have to do is known as outsourcing. In this lesson, we're going to look at the relevant costs that companies must consider when making the decision to outsource, along with other qualitative factors to examine before deciding to buy a service or good instead of making or providing it itself.

Calculating Relevant Costs

While many people often think of just services as needing outsourcing, the fact is that plenty of goods are outsourced too. In fact, being able to buy a good for less than you can produce it is a prime reason to outsource.

Let's look at the math involved to make that determination. First, we have to calculate the cost of actually making the component or providing a service. Not only does that include the cost of materials, but it also includes the cost of labor as well as any fixed or variable overhead costs. Next, we compare that cost to the price that the firm is selling the good or service for. If the firm can provide the good or service for a cheaper price, then it is a strong indication that the company should purchase from that supplier.

Considering Qualitative Factors

However, cost is not everything. There are also a number of qualitative factors that must be considered when making the decision to outsource. Most obviously, there is the fact that outsourcing would likely result in a loss of jobs at your company. Layoffs are never popular with staff, and that could create a morale problem. Additionally, one must examine if the good being purchased is of the same quality as what could be made in house.

Furthermore, there are greater impacts to consider. While your company may pride itself on the way it treats its employees or the way it acts as a steward of the environment, the chosen supplier may see things differently. As a result, while you may regard your company well by going green or paying higher wages, it may be likely that the good work you're trying to enact is being undone by the company you pay in order to get goods or services.

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