Don’t fall into the “Unit Cost” trap when deciding on outsourcing
Manufacturing companies frequently face the classic dilemma: Make a component in-house or Buy it from a supplier?
It seems obvious: just compare the purchase price with your production cost. But this is a flawed approach. Why? Because fixed costs do not disappear even if you switch entirely to purchasing.
I previously discussed the “Death Spiral” in management accounting in my article “Cost Traps (Part 1)” , illustrating how decisions based on full absorption costing instead of contribution margin can destroy a business.
However, simply comparing variable costs with the purchase price is also not enough.
- Why can buying be profitable even if the price is higher than your production cost?
- What other factors are critical for a sound decision?
Let’s dive into the mechanics of the “Make or Buy” decision.
The Typical Mistake
“Our production cost for the component is 100 UAH. The supplier offers it for 90 UAH. The benefit is obvious, right? Wrong.”
Why is this a mistake? Because accounting (full) cost includes fixed costs: rent, depreciation, general plant expenses. If you stop production and start buying, these fixed costs do not vanish. Even wages (hourly or piece-rate) are not always fully variable in the short term — you cannot fire skilled workers instantly, and often you still pay for downtime.
The Right Approach: Relevant Costs
Management accounting recommends considering only Relevant Costs — those that actually change the cash flow as a result of the decision.
Example 1: The Idle Capacity Scenario Imagine you have spare capacity.
- Variable cost to make: 60 UAH
- Fixed cost (allocated): 40 UAH (Irrelevant, as it stays anyway)
- Supplier price: 90 UAH
The Real Choice:
- Make: You spend 60 UAH (cash outflow).
- Buy: You spend 90 UAH (cash outflow).
Verdict: It is more profitable to MAKE it yourself. The allocated fixed costs are irrelevant here.
The Game Changer: Opportunity Cost
But that’s not the whole picture. What if your resources are scarce?
If your equipment or team is a Bottleneck (Constraint) that holds back overall growth, the logic changes completely.
Example 2: The Bottleneck Scenario (Recommended Addition) Suppose making Component A takes 1 hour of machine time.
- Variable Cost to Make: 60 UAH.
- Supplier Price: 90 UAH. (Buying seems 30 UAH more expensive).
BUT: If you stop making Component A, you free up 1 hour of machine time. You can use this hour to produce Product B, which generates a contribution margin of 50 UAH.
Calculation:
- Cost to Buy: -90 UAH
- Savings on Make: +60 UAH
- Gain from Product B: +50 UAH
- Net Benefit: +20 UAH
In this case, it is profitable to BUY the component for 90 UAH (even if it costs 60 to make!) because it unlocks the ability to earn more on other products.
Beyond Finance: Qualitative Factors
A financial calculation is necessary but not sufficient. You must consider the strategic risks:
- Quality Control & Lead Times: Can the supplier guarantee stability? A cheap component that stops the assembly line is very expensive.
- Scalability: Is it easy to increase/decrease order volumes if demand changes?
- Core Competence: Is this component your competitive advantage? (e.g., Apple doesn’t outsource its OS design, but outsources assembly).
- IP Risks: Risk of technology leakage.
- Employee Morale: Layoffs due to outsourcing can demotivate the remaining staff.
Summary
- Ignore Sunk Costs: Allocated fixed costs should not influence the decision.
- Calculate Opportunity Cost: Always ask: “What else could we do with these resources?”
- Think Strategically: Don’t sacrifice quality or control for short-term savings.
The “Make or Buy” decision is not just about money. It’s about strategy, flexibility, and the future of your company.
I touched upon the topic of irrelevant costs in my article «Special Orders: Should You Accept a Price Below Production Cost?» and «Costing Traps (Part 1)».
