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How to perform a make vs buy analysis?

Make vs buy is a concept tested on the BEC section of the CPA exam, but it is also a type of analysis that real world companies perform daily. Just as it sounds, in a make vs buy analysis, a company is trying to determine whether they should continue to manufacture a part in-house or buy it from a supplier. Companies have to make these decisions every day and they should consider qualitative and qualitative factors:

Some companies will look purely at the cost. Is it cheaper to make the product or is it cheaper to buy it from a supplier. Other companies will consider qualitative factors such as reputation, reliability, and other pros or cons. On the CPA exam, the decision will most likely be driven by cost as that is a very objective point of view. However, in the real world, qualitative factors should be considered, but those are more subjective and every company will have a different view on what qualitative factors are relevant.

Example of Make vs Buy Analysis

Let’s take a look at an example as learning to apply a topic is the best way to master a concept.

Zire, an electric car company, is considering outsourcing one of the component parts for its product. The company currently makes 10,000 parts per month. The company incurs total direct materials of $40,000, total direct labor of $30,000 and total fixed factory overhead of $20,000.

Zire decides to purchase the part for $8 per unit from another supplier and rents its idle capacity for $5,000/month. How will the company’s monthly costs change?

Solution for Example

Step 1) Let’s start by calculating the cost to purchase. Zire will purchase the part for $8 and they need 10,000 parts per month. That results in a cost to purchase of $80,000 per month.

Step 2) Now we need to figure out what costs can be avoided. These are typically variable production costs like direct materials and direct labor. Fixed costs generally can’t be avoided, but it does say the company can now rent the idle space for $5,000 per month. So, our avoidable costs are $40,000 of direct materials, $30,000 of direct labor, and $5,000 of rent. That totals avoidable costs of $75,000.

Step 3) Now we just take the difference, and we can see that monthly costs will increase $5,000 since Zire decided to purchase the part from the supplier. If I were advising them, I would have told them it is cheaper to make the part!

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