Make-or-Buy and Relevant Costs
The discipline of deciding whether to produce in-house or source outside by counting only the costs that actually change - future, incremental and avoidable - and refusing to let sunk spend or unavoidable overhead cast a vote.
A make-or-buy decision compares the cost of producing a component or service internally against the cost of buying it from an outside supplier, and it should be settled on relevant costs alone. A cost is relevant only if it is both a future cost and one that differs between the two options - in short, a future, incremental, avoidable cash flow. Costs already incurred (sunk costs) are irrelevant, and so is any fixed cost that will continue regardless of the choice. The decision rule is simple: compare the avoidable cost of making with the purchase price, then add back the opportunity cost of any capacity that making ties up - the contribution the firm forgoes by not using that capacity for its next-best purpose. Where the numbers are close, qualitative factors - quality control, supply security, intellectual property and supplier dependence - become decisive. The framework is simple to state and easy to misuse, because the tempting numbers are usually the irrelevant ones.
Only future, incremental, avoidable costs count
Relevant costing strips a decision down to the cash flows that the decision itself changes. A cost qualifies on two tests at once. First, it must lie in the future: money already spent is gone and cannot be altered by any choice made today. Second, it must differ between the alternatives: if a cost is identical whether the firm makes or buys, it cancels out and can be ignored without affecting the answer. Put the two together and the relevant costs of a make-or-buy call are the future, incremental cash flows that appear under one option and not the other.
Two categories trip up managers most often. Sunk costs - the tooling already bought, the R&D already expensed, the machine already depreciating - feel important precisely because they were expensive, but they are the same under both options and therefore irrelevant. Unavoidable fixed costs - the factory rent, the plant manager's salary, general overhead that will be reallocated rather than removed - are the subtler trap. Standard costing spreads them across units, so a "full cost per unit" of making includes overhead that will not disappear if production stops. Buying does not save that overhead; it simply moves it onto the units that remain. Only the fixed costs that genuinely vanish when you stop making - the avoidable ones - belong in the comparison.
Opportunity cost of capacity
The relevant-cost comparison is incomplete until it accounts for what the making option consumes but never invoices: capacity. If a firm makes a part on a line that would otherwise produce something profitable, the contribution given up on that other work is a real economic cost of making - an opportunity cost - even though no cash leaves the building and no ledger records it. When capacity is idle, its opportunity cost is zero and the comparison is a straight cash contest. When capacity is scarce, the opportunity cost can be the largest number in the analysis and can flip a decision that looked obvious on cash alone.
This is why the make-or-buy question is really a capacity question in disguise. The right frame is: what is the incremental cash cost of making, plus the contribution the firm forgoes by using constrained capacity to make rather than to do its next-best alternative, versus the price of buying and freeing that capacity? Opportunity cost is invisible to the accounting system and decisive in the decision.
Make vs buy with an avoidable-fixed and an opportunity-cost twist
A manufacturer needs 20,000 units a year of a component (illustrative figures, not client data). Making it in-house costs, per unit: direct materials €6, direct labour €4, and variable overhead €2 - so €12 of variable cost. The accounting system also loads €5 of fixed overhead onto each unit, giving a reported "full cost" of €17. A supplier offers to deliver the same component for €15 per unit. On full cost the answer looks easy: making at €17 beats buying at €15, so buy. But that reasoning is wrong until the €5 is interrogated.
Of the €5 fixed overhead per unit (€100,000 in total), suppose €3 per unit (€60,000) is avoidable - a supervisor and a maintenance contract that end if the line stops - while €2 per unit (€40,000) is unavoidable allocated plant overhead that continues either way. The relevant cost of making is therefore the €12 variable plus the €3 avoidable fixed = €15 per unit, or €300,000 a year. Buying costs 20,000 × €15 = €300,000. On cash flows alone the two options tie; the €2 of unavoidable overhead that made buying look cheaper was never a saving at all.
Now the twist. If the firm buys, the freed line can produce a different product generating €25,000 of annual contribution. That €25,000 is an opportunity cost of making. Adding it, making effectively costs €300,000 + €25,000 = €325,000 against buying at €300,000, so buying now wins by €25,000 a year. Had the line instead stayed idle, the opportunity cost would be zero and the decision would remain a coin-flip to be broken on qualitative grounds. Same components, same prices - three different answers depending on which costs are allowed to speak.
What goes into the comparison, and what stays out
| Cost or factor | Relevant to make-or-buy? |
|---|---|
| Direct materials, labour and variable overhead of making | Yes - future and incremental; they disappear if you buy |
| Avoidable fixed costs (supervision, dedicated maintenance, a leasable machine) | Yes - they genuinely vanish when production stops |
| Contribution forgone on freed capacity | Yes - opportunity cost; real even though no cash records it |
| Purchase price and inbound logistics from the supplier | Yes - the incremental cash outflow of buying |
| Allocated general overhead that continues either way | No - unavoidable; reallocated, not removed |
| Tooling, R&D and depreciation already incurred | No - sunk; identical under both options |
The pattern is consistent: the costs the accounting system reports most prominently - full absorbed cost per unit - are exactly the ones most likely to mislead, because they blend avoidable and unavoidable, incurred and future. Rebuilding the number from relevant cash flows is the whole job. That is the bridge to the rest of this encyclopedia: knowing which fixed costs are truly avoidable and what a unit of capacity is worth is precisely what time-driven activity-based costing and cost-to-serve analysis quantify, while the opportunity cost of capacity is the same scarcity logic that customer- and product-profitability analysis and the whale curve use to decide which work deserves the firm's constrained resources.
When relevant costing earns its keep - and the qualitative check
Strengths. The relevant-cost framework cuts through allocated-cost noise and points at the cash that a decision actually moves. It exposes the two classic errors - counting sunk costs and counting unavoidable overhead - and it forces capacity to be priced through opportunity cost rather than ignored. For a bounded, short-run sourcing question it is the correct and fastest lens.
Limits and qualitative factors. A make-or-buy decision is rarely only arithmetic. Outsourcing surrenders control over quality and lead time, creates supplier dependence and switching cost, can leak intellectual property or strategic know-how, and exposes the firm to price rises once its own capability has atrophied. Making preserves control and learning but ties up capital and management attention. Relevant costing sizes the financial gap; when that gap is small - as in the tie above - these strategic factors, not the spreadsheet, should decide. And the framework is short-run by nature: over a long horizon few costs stay fixed and today's avoidable-versus-unavoidable split will itself shift.
Common questions about make-or-buy and relevant costs
- What is a relevant cost?
- A relevant cost is a future cash flow that differs between the alternatives under consideration - in short, future, incremental and avoidable. If a cost has already been incurred, or is the same whichever option you choose, it is irrelevant to the decision and should be excluded, however large it looks.
- Why are sunk costs ignored in a make-or-buy decision?
- Because they cannot be changed by the decision. Tooling already bought, R&D already expensed and machines already depreciating are the same under both making and buying, so they cancel out. They feel important because they were costly, but no future choice can recover them, which is exactly why they carry no weight.
- How do fixed costs affect a make-or-buy decision?
- Only the fixed costs that genuinely disappear if you stop making - avoidable fixed costs - are relevant. Allocated overhead that continues regardless (rent, general management, plant costs reallocated to other units) is unavoidable and must be stripped out. Using a full absorbed cost per unit is the most common way to reach the wrong answer.
- What is the opportunity cost of capacity, and why does it matter?
- It is the contribution the firm gives up by using constrained capacity to make a part rather than for its next-best use. When capacity is scarce, this uninvoiced cost can be the largest and most decisive number in the analysis; when capacity is idle, it is zero. Ignoring it systematically biases the decision toward making.
- What qualitative factors should sit alongside the numbers?
- Quality and reliability of supply, control over lead times, protection of intellectual property and know-how, the switching cost and dependence created by a single supplier, and the strategic importance of retaining the capability in-house. When the relevant-cost gap between making and buying is small, these factors, not the spreadsheet, should carry the decision.
References
Horngren, C. T., Datar, S. M. & Rajan, M. V. Cost Accounting: A Managerial Emphasis (chapters on relevant costs and the make-or-buy decision). · Drury, C. Management and Cost Accounting (relevant costs for decision-making and opportunity cost). · Garrison, R. H., Noreen, E. W. & Brewer, P. C. Managerial Accounting (differential analysis and outsourcing decisions). · Kaplan, R. S. & Cooper, R. Cost & Effect (using cost information for capacity and sourcing decisions). · CIMA, Official Terminology (definitions of relevant cost, sunk cost, avoidable cost and opportunity cost).