Make-or-Buy Analysis and Decision Making

Make-or-Buy Analysis and Decision Making: A Comprehensive Guide for CPIM Exam Success

Introduction to Make-or-Buy Analysis

Make-or-buy analysis is one of the most critical decision-making frameworks in supply chain and operations management. It involves evaluating whether a company should manufacture a component, product, or service internally (make) or purchase it from an external supplier (buy). This analysis sits at the heart of internal supply source decisions and is a key topic in the CPIM (Certified in Planning and Inventory Management) certification exam.

Why Is Make-or-Buy Analysis Important?

Make-or-buy decisions have far-reaching consequences for an organization. Understanding why this analysis matters will help you appreciate its significance both in practice and on the exam:

1. Cost Optimization: The most obvious reason is cost. Organizations must determine whether producing in-house is cheaper than outsourcing, considering all relevant costs — not just the unit price.

2. Core Competency Focus: Companies should focus resources on what they do best. Make-or-buy analysis helps organizations identify which activities are core competencies worth retaining and which can be outsourced.

3. Capacity Utilization: If a company has idle capacity, it may be more economical to make a component internally. Conversely, if capacity is constrained, buying may free up resources for higher-priority production.

4. Supply Chain Risk Management: Relying solely on external suppliers introduces risks such as supply disruptions, quality inconsistencies, and lead time variability. Making in-house can mitigate some of these risks.

5. Strategic Positioning: Some decisions are driven by long-term strategy — protecting intellectual property, maintaining control over quality, or building capabilities for future products.

6. Flexibility and Responsiveness: Internal production may offer greater control over scheduling and responsiveness to demand changes, while outsourcing may offer scalability.

What Is Make-or-Buy Analysis?

Make-or-buy analysis is a structured evaluation process that compares the total costs, risks, and strategic implications of producing an item internally versus purchasing it from an external source. It is a form of sourcing decision that considers both quantitative (financial) and qualitative (strategic) factors.

Key Definitions:

- Make: The decision to produce a component, subassembly, or finished product using the organization's own resources, including labor, equipment, and materials.

- Buy: The decision to procure the item from an external supplier or subcontractor.

- Relevant Costs: Only those costs that differ between the make and buy alternatives should be considered. Sunk costs and costs that remain the same regardless of the decision are excluded.

- Incremental Cost: The additional cost incurred by choosing one option over another.

- Opportunity Cost: The benefit foregone by choosing one alternative over another (e.g., using capacity to make a component means that capacity cannot be used for another profitable product).

How Does Make-or-Buy Analysis Work?

The make-or-buy analysis follows a systematic process. Here is a step-by-step breakdown:

Step 1: Identify the Item or Service Under Review
Determine which component, product, or service is being evaluated. This could be triggered by new product introduction, cost reduction initiatives, capacity changes, or supplier performance issues.

Step 2: Gather Cost Data
Collect all relevant cost information for both alternatives:

Costs to Make (Internal Production):
- Direct materials
- Direct labor
- Variable manufacturing overhead
- Incremental fixed overhead (additional equipment, tooling, etc.)
- Setup and changeover costs
- Quality control and inspection costs
- Inventory carrying costs for raw materials and WIP

Costs to Buy (External Procurement):
- Purchase price per unit
- Transportation and freight costs
- Receiving and inspection costs
- Purchase order and administrative costs
- Inventory carrying costs for purchased items
- Quality assurance costs (incoming inspection)
- Potential tariffs or duties

Step 3: Perform Quantitative Analysis

The basic quantitative comparison involves calculating the total relevant cost for each option:

Total Cost to Make = Direct Materials + Direct Labor + Variable Overhead + Incremental Fixed Costs

Total Cost to Buy = Purchase Price + Freight + Receiving/Inspection + Administrative Costs

Break-Even Analysis:
A common quantitative tool is break-even analysis. The break-even point is the volume at which the total cost of making equals the total cost of buying.

Break-Even Quantity = Fixed Costs of Making ÷ (Purchase Price per Unit – Variable Cost per Unit to Make)

- Below the break-even quantity, it is typically cheaper to buy because fixed costs of making are spread over fewer units.
- Above the break-even quantity, it is typically cheaper to make because the lower variable cost per unit offsets the fixed investment.

Step 4: Consider Qualitative Factors

Quantitative analysis alone is insufficient. The following qualitative factors must also be weighed:

Factors Favoring Make:
- Desire to maintain control over quality
- Protection of proprietary technology or trade secrets
- Unreliable suppliers or lack of competent suppliers
- Utilization of existing idle capacity and workforce
- Shorter and more controllable lead times
- Lower long-term costs through learning curve effects
- Strategic importance of the item to the core business
- Political, social, or environmental considerations (e.g., keeping jobs local)

Factors Favoring Buy:
- Supplier has specialized expertise or superior technology
- Lower cost due to supplier's economies of scale
- Insufficient internal capacity or capability
- Desire to focus on core competencies
- Demand is too small to justify the investment
- Need for multiple sources to reduce supply risk
- Temporary or uncertain demand (avoids fixed cost commitment)
- Faster time to market through experienced suppliers
- Avoidance of capital investment in equipment and facilities

Step 5: Assess Risks

Risk assessment is a critical part of the analysis:

- Supply Risk: What happens if the supplier fails to deliver? Are there backup sources?
- Quality Risk: Can the supplier consistently meet quality standards?
- Technology Risk: Will outsourcing lead to loss of proprietary knowledge?
- Financial Risk: What if demand changes significantly? Which option offers more flexibility?
- Dependency Risk: Over-reliance on a single supplier can create vulnerability.

Step 6: Make the Decision

Combine quantitative results, qualitative assessments, and risk evaluations to arrive at a recommendation. The decision should align with the organization's overall strategy.

Step 7: Monitor and Review

Make-or-buy decisions should be revisited periodically as conditions change — new technologies, shifts in demand, changes in supplier capabilities, or internal capacity adjustments may alter the optimal decision.

Advanced Considerations for CPIM

1. Total Cost of Ownership (TCO):
The CPIM exam emphasizes TCO, which goes beyond the simple purchase price or manufacturing cost. TCO includes all costs across the product's lifecycle: acquisition costs, operating costs, maintenance, disposal, and hidden costs such as quality failures, expediting, and lost sales due to delivery delays.

2. Opportunity Cost:
If internal capacity used to make a component could instead be used to produce a more profitable product, the opportunity cost must be factored into the analysis. This is a commonly tested concept.

Example: If making Component A uses capacity that could generate $50,000 in contribution margin from Product B, that $50,000 is an opportunity cost of making Component A.

3. Avoidable vs. Unavoidable Costs:
Only avoidable costs (costs that will disappear if the item is outsourced) are relevant. Unavoidable costs (such as allocated fixed overhead that will continue regardless) should be excluded from the analysis.

This is a critical exam concept: If a question states that allocated overhead of $10 per unit is assigned to the product but will not be eliminated if the product is outsourced, that $10 is not a relevant cost in the make-or-buy decision.

4. Learning Curve Effects:
If internal production is expected to benefit from learning curve effects (costs decrease as cumulative production increases), this should be factored into the long-term make analysis.

5. Capacity Constraints:
When capacity is a binding constraint, the analysis should consider the contribution margin per unit of the constraining resource (e.g., per machine hour or per labor hour). Items with lower contribution per constraint unit may be better candidates for outsourcing.

Worked Example

A company needs 10,000 units of Component X per year. Here is the cost comparison:

Make:
- Direct materials: $8 per unit
- Direct labor: $5 per unit
- Variable overhead: $3 per unit
- Incremental fixed costs: $40,000 per year
- Total variable cost per unit: $16
- Total cost to make: (10,000 × $16) + $40,000 = $200,000

Buy:
- Purchase price: $22 per unit
- Freight and handling: $1 per unit
- Total cost per unit: $23
- Total cost to buy: 10,000 × $23 = $230,000

Decision: At 10,000 units, making is cheaper by $30,000.

Break-Even Calculation:
Break-Even Quantity = $40,000 ÷ ($23 – $16) = $40,000 ÷ $7 = 5,714 units

Below 5,714 units, buying is cheaper. Above 5,714 units, making is cheaper.

Now add an opportunity cost: If the capacity used to make Component X could instead generate $45,000 in profit from another product:

Adjusted total cost to make: $200,000 + $45,000 = $245,000
Total cost to buy: $230,000

Revised decision: With the opportunity cost, buying is now cheaper by $15,000.

This type of scenario adjustment is very common in CPIM exam questions.

Common Exam Scenarios and How to Approach Them

Scenario 1: Simple Cost Comparison
You are given make costs and buy costs. Calculate totals and compare. Remember to include only relevant costs.

Scenario 2: Allocated Fixed Overhead Trap
A question includes allocated fixed overhead in the make costs. Read carefully — if the overhead is unavoidable (will continue even if you buy), exclude it from the make cost.

Scenario 3: Opportunity Cost Adjustment
The freed-up capacity can be used for another profitable activity. Add the opportunity cost to the make option or subtract it from the buy option to see the net effect.

Scenario 4: Qualitative Override
Even if the numbers favor one option, qualitative factors (e.g., protecting IP, unreliable suppliers, strategic importance) may change the decision. Be prepared to identify when qualitative factors should override quantitative results.

Scenario 5: Break-Even Volume
You need to find the volume at which make and buy costs are equal. Use the break-even formula and determine which option is better above and below that volume.

Scenario 6: Capacity Constraint with Multiple Products
When capacity is limited, calculate the contribution margin per constraining resource for each product. Outsource the product with the lowest contribution per constraint unit.

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Exam Tips: Answering Questions on Make-or-Buy Analysis and Decision Making

Tip 1: Focus on Relevant Costs Only
The single most important skill in make-or-buy questions is identifying relevant costs. Only costs that differ between the make and buy alternatives matter. Ignore sunk costs, unavoidable fixed costs, and allocated overhead that will not change regardless of the decision. If a question mentions that allocated overhead will continue whether the item is made or bought, do not include it in your make cost.

Tip 2: Watch for the Allocated Overhead Trap
This is the most common trap in CPIM make-or-buy questions. Exam writers will often include allocated corporate or plant overhead in the make cost to inflate it. Always ask: Will this cost go away if we stop making the item? If not, exclude it.

Tip 3: Always Consider Opportunity Cost
If the question mentions that freed capacity can be used for another purpose (another product, rental income, etc.), you must include that opportunity cost. Add it to the make side or recognize it as a benefit of buying.

Tip 4: Know the Break-Even Formula
Memorize: Break-Even Quantity = Incremental Fixed Costs of Making ÷ (Cost per Unit to Buy – Variable Cost per Unit to Make). Below this quantity, buy. Above this quantity, make. Questions may ask you to determine the volume at which the company should switch strategies.

Tip 5: Don't Ignore Qualitative Factors
Some questions are designed to test whether you understand that the lowest cost option is not always the best option. If the question describes concerns about quality, IP protection, supply security, or strategic capability, be prepared to recommend making even if buying appears cheaper (or vice versa).

Tip 6: Use Total Cost of Ownership Thinking
When comparing options, think beyond the purchase price. Include transportation, inspection, quality costs, administrative costs, and carrying costs. The CPIM exam expects you to apply TCO principles.

Tip 7: Read the Question Twice
Make-or-buy questions often contain subtle details that change the answer. Read the question carefully, identify all given cost elements, and categorize them as relevant or irrelevant before calculating.

Tip 8: Remember the Strategic Dimension
The CPIM body of knowledge emphasizes that make-or-buy is not purely a financial decision. It is a strategic sourcing decision. Be familiar with concepts like core competency, vertical integration, supply risk, and supplier relationship management.

Tip 9: Practice with Numbers
Work through multiple practice problems. The exam will likely present scenarios with various cost elements, and speed in identifying relevant costs and performing calculations is essential.

Tip 10: Understand the Relationship to Capacity Planning
Make-or-buy decisions are directly connected to capacity management. When demand exceeds capacity, outsourcing becomes more attractive. When there is excess capacity, making in-house can absorb fixed costs and improve capacity utilization. Expect questions that link these concepts.

Tip 11: Know When to Revisit the Decision
The exam may test your understanding that make-or-buy is not a one-time decision. Changes in demand volume, technology, supplier performance, internal capabilities, or market conditions should trigger a reassessment.

Quick Reference Summary Table

Factor | Favors Make | Favors Buy
Cost at high volume | ✓ |
Cost at low volume | | ✓
Core competency | ✓ |
Non-core activity | | ✓
Idle capacity available | ✓ |
No available capacity | | ✓
IP protection needed | ✓ |
Supplier has superior technology | | ✓
Unreliable suppliers | ✓ |
Need for flexibility/scalability | | ✓
Quality control critical | ✓ |
Capital investment avoidance | | ✓

Conclusion

Make-or-buy analysis is a foundational concept in the CPIM exam and in practical supply chain management. Mastering this topic requires understanding both the quantitative mechanics (cost comparison, break-even analysis, opportunity cost) and the qualitative strategic considerations (core competency, risk, IP protection, capacity). On the exam, always focus on relevant costs, watch for common traps like allocated overhead, consider opportunity costs, and remember that the best decision integrates financial analysis with strategic thinking.