Make-or-Buy Decisions: The Accounting Behind Them

"Should we make this in-house or buy it ready-made?" The question comes up for components, sub-assemblies, packaging, software — almost any input you could either produce or procure. The right framework is the relevant-costing lens. Here is how to use it cleanly.

The principle: relevant costs only

The only costs that matter in a make-or-buy decision are the costs that change as a result of the decision. Everything else is a sunk cost or a fixed cost that exists either way — and it does not deserve weight in the comparison.

That sounds obvious. In practice it is the single biggest source of bad make-or-buy decisions.

What "relevant" actually means

For the make side, relevant costs typically include:

• Direct material consumed
• Direct labour — but only if you would actually hire / pay overtime / lose other output by making this in-house
• Variable overhead — power, consumables, machine wear that varies with the run
• Avoidable fixed costs — fixed costs that genuinely disappear if you do not make this (rare, but real)
• Opportunity cost — the contribution lost on whatever else those resources could be doing

For the buy side, relevant costs include:

• The supplier's price
• Freight in (and out, if there is a returns flow)
• Receiving, inspection, handling
• Quality cost (incoming inspection, rejections, supplier-management overhead)
• Lead-time / inventory cost — longer supplier lead time = more buffer stock = working capital
• Risk premium — supplier reliability, single-source risk

Fixed overhead that exists either way — building rent, plant manager salary, depreciation on idle equipment — does not belong on either side. It is irrelevant to the decision because it does not change.

Worked example

A workshop is deciding whether to make or buy plastic handles for its cabinets.

Make:

• Material: ₹8/handle
• Direct labour: ₹6/handle (existing worker; would otherwise be partially idle)
• Variable overhead: ₹2/handle
• Allocated fixed overhead: ₹4/handle ← not relevant; rent and depreciation exist either way

Relevant make cost: ₹16/handle (not ₹20)

Buy:

• Supplier price: ₹18/handle
• Freight + handling: ₹1/handle
• Quality cost (rejections): ₹0.50/handle

Relevant buy cost: ₹19.50/handle

Decision: make — by ₹3.50/handle.

But wait. The labour bullet said "existing worker; would otherwise be partially idle." What if that worker could instead be making something else worth ₹10/hour in margin, and a handle takes 0.5 hours? That is an opportunity cost of ₹5/handle of make. Adding it: ₹21/handle to make → buy wins by ₹1.50.

The numbers can flip on a single assumption. Be honest about each one.

Common traps

• Including fixed overhead. The single most common error. If the rent does not change, do not put it on the make side.
• Ignoring opportunity cost. If your capacity is constrained and making this displaces something else, the displaced thing's contribution is a real cost of making.
• Treating supplier price as the full buy cost. Add freight, quality, handling, working-capital impact — the gap closes meaningfully.
• Assuming labour is free because they are already paid. Only true if they would otherwise be genuinely idle. If you could redeploy them, their time is not free.
• Comparing average costs. Make-or-buy is about incremental costs. Averages mix in things that do not change with the decision.

Strategic factors that override the math

Even when the math is clear, a few qualitative considerations can flip the decision:

• Strategic dependency — does buying create a critical single-supplier risk?
• IP / process knowledge — does making preserve a capability you want to own?
• Quality consistency — does only in-house give you the control you need?
• Lead time / flexibility — does in-house give you customer-responsiveness that pays off in price?
• Volume future — is this a growing volume (favours make, with scale) or shrinking (favours buy)?

A typical pattern: the math favours buy for low volumes, make for high volumes. The cross-over point is what to identify, not just "which is cheaper today."

The decision is rarely permanent

Make-or-buy is not a one-time call. Volumes shift, supplier markets evolve, your own capacity changes. Revisit the analysis annually for any non-trivial component. The right answer this year may be the wrong answer in two years.

How Booksmor helps

Booksmor's costing per item — broken into material, labour, variable overhead and (separately) absorbed fixed overhead — gives you the inputs for a relevant-cost comparison without guesswork. Side-by-side with vendor purchase history, the make vs buy gap is visible per item. Start a 30-day free trial and make make-or-buy a real analysis.