MAKE OR BUY DECISIONS , Managerial Accounting

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MAKE OR BUY DECISIONS (NO LIMITING FACTORS)

The choice between making and buying a given component is one which is likely to face all businesses at some time.  It is often one of the most important decisions for management for the critical effect on profits that may ensue. The choice is critical, too, for the management accountant who provides the cost data on which the decision is ultimately based.

A make or purchase problem includes a decision by an organization about whether it must make a product or taken out an activity with its own internal resources or whether it should pay another organisation to carry out the activity. The make option gives management more direct control over the work, but the buy option may have benefits in that the external organisation has expertise and special skills in the work making it cheaper.

There are certain situations where the make or buy decision is not really a choice at all. There can be no alternative to making, where product design is confidential or the methods of processing are kept secret.  On the other hand, patents held by suppliers may preclude the use of certain techniques and then there is no choice other than buying or going without. The supplier who has developed a special expertise or who uses highly specialized equipment may produce better-quality work which suggests buying rather than making. In other cases, the special qualities demanded in the product may not be available outside and so making becomes necessary.

Where technical considerations do not influence the make or buy decision, the choice becomes one of selecting the least-cost alternative in each decision situation. Comparative cost data are necessary, therefore, to determine whether it is cheaper to make or to buy. In general this requires a comparison of the respective marginal costs or, in some cases, the incremental costs of each alternative. Incremental costs are relevant in decisions which include capacity changes. For example, a certain component has always been bought out because the plant and equipment for its manufacture has not been installed in the factory. When considering the alternative to buying, the cost of making comprises all the incremental costs (including additional fixed expenditure) arising from the decision. The incremental cost also includes the opportunity cost of the investment in capital equipment, that is, the expected return from an alternative investment opportunity. A decision to buy a part which has previously been manufactured may release capacity for other uses or for disposal so that the incremental cost of the decision also includes the relevant fixed-cost savings.


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