Explanation with Solved Example:
Sometimes businesses encounter a situation where they have to decide between making a particular product themselves or to buy it from an outside supplier. The decision is based on both financial and non-financial factors.
In general proposed purchased price is compared with the marginal cost of production. If marginal cost of the production are more than the price offered by the outside supplier then clearly buying goods in finished form is a better option. When manufacture of goods displaces existing production, the alternative use of plant etc., currently employed in manufacturing must be taken into consideration.
To make or buy decision may well be influenced by the availability of spare capacity. If the business has spare capacity and other conditions are favorable then it will be relatively cheap to manufacture the product. However, if the spare capacity is not available, the firm will have to displace production of another product in order to make capacity available to manufacture the product.
Factors to Make or Buy Decisions:
There are two important factors to make or buy decisions:
(1) Quantitative factors and (2) Qualitative factors
(1) Quantitative Factors to Make or Buy Decisions:
To understand about quantitative factors, read the following example:
Furniture Inn manufactures computer tables. Recently a supplier has offered the tables of the same quality @ $14 each with an assurance of continued supply. The following is the budget for 4000 units prepared for the quarter ending 30 September 2016:
(a) Should Furniture Inn accept the offer from the supplier?
(b) What would be the decision if the supplier offered the tables at $12 each?
Calculation of per table marginal cost of production
(a) As marginal cost of production is less than the buying price offered by the supplier so Furniture Inn should continue production of tables. The distribution, administration and fixed production are irrelevant in the decision as presumptively they will be incurred in either case.
(b) As in this case they buy in price $12 is less than the marginal cost of production so Furniture Inn should buy the tables from the supplier and discontinue production of tables provided other things are favorable.
(2) Qualitative Factors to Make or Buy Decision:
Though quantitative considerations are important and may be decisive but make or buy decision may not be appropriate if relevant qualitative factors are ignored. Some of the qualitative factors relating to make or buy decision are as follows:
(1) Quality and reliability of goods to be bought as a defective component may damage the reputation and reliability of the firm’s ability.
(2) Reliability of the supplier on timely deliveries of goods as an interruption in the delivery of a component part may significantly affect a firm’s operations.
(3) Possibility of ceasing production in near or medium distance future.
(4) Can guarantee be obtained from the supplier about no price change in foreseeable future? A long term contract with a reliable supplier may solve this problem.
(5) Can an alternative use be found for resources made idle by a decision to purchase from outside.
(6) How long it would take to start manufacturing the product/component again if supplier fails to deliver as promised. Retaining and rehiring of personnel may be important considerations.
(7) What would be the cost of closing down the production line?
(8) Foreign exchange rates and their effects on the decision.
(9) Import policies and their consistency.
Note: Last two points are applicable only to purchase of goods from a foreign country.