Make or Buy

Compare making in-house versus buying: full cost both, then weigh control, capacity and risk.

Time45 min
FormatSmall group
StageEvaluate

Make or Buy: what it is and why it works

Make or Buy compares producing a part, module or service in-house with sourcing it from a supplier, costing both options completely before weighing the strategic factors. The make side includes material, direct labor, machine time, the overhead that would genuinely change, quality costs and the capital tied up in equipment and inventory. The buy side includes the price, freight, duties, incoming inspection, inventory carrying cost, supplier management, switching risk and the cost of exiting later. Only after both totals are on the table does the team add control, capacity, confidentiality and competence building, and decide part by part.

The method matters because most make-or-buy positions are inherited, not decided. A shop keeps machining a component because it always has, or outsources it because the full-absorption cost looks high, even though much of the allocated overhead would stay if the work left. Separating avoidable costs from allocated ones is the core analytical step. Transaction cost economics, from Coase onward, explains why the answer depends on asset specificity, uncertainty and frequency, not just unit price. Make or Buy links to Process Rethink, because a new process may only be available externally, to Life Cycle Cost for long-horizon effects, and to the Quote Comparison Grid, which makes the buy side comparable across suppliers.

What you need

List of candidate parts or modules with annual volumes and forecast
Current make cost broken into material, labor, machine, avoidable and allocated overhead
Normalized supplier quotes including logistics, tooling and payment terms
Capacity situation of the plant and the equipment involved
Strategic criteria agreed with management: core competence, IP sensitivity, supply risk

What you get

Side-by-side total cost for make and buy per part
Avoidable versus allocated cost split, with the effect on plant overhead absorption
Strategic scoring per part
Decision per part with review date and exit conditions
A portfolio view showing which families stay in-house and why

When to use it

When the default answer has been the same for a decade.

How to do it, step by step

List the parts or modules in question with their volumes.
Cost the make option fully: material, labor, machine, overhead, quality, capital.
Cost the buy option fully: price, logistics, inventory, switching risk, exit cost.
Add the strategic factors: competence building, capacity risk, confidentiality.
Decide per part, review annually — the answer changes with volume.

Worked example: Machined manifold blocks at a hydraulic power unit builder

Illustrative scenario — figures are realistic but not from a real company.

A builder of hydraulic power units for steel mills and presses machines about 40 manifold block designs in-house, roughly 2,600 blocks a year. Finance showed a full-absorption cost of $385 per average block, and a regional machining supplier quoted $310 delivered.

The team split the $385 into $95 of material, $120 of direct labor and machine time, and $170 of overhead. Only about $60 of that overhead would disappear if the work left, since the building, supervision and ERP costs would remain.
The buy side added $18 for incoming inspection and supplier management, $12 of inventory carrying cost for larger batches, and a switching risk on the 6 designs with proprietary porting.
Avoidable make cost came to about $275 against a buy total near $340.
Strategically, the proprietary designs held know-how the company wanted to protect, while 22 simple standard blocks did not.

Result. The company kept the proprietary and complex blocks in-house, freeing machine capacity by outsourcing the 22 standard designs, where the supplier's dedicated cells gave a real advantage. The freed capacity absorbed a growing valve-machining workload without a new machine purchase. Lesson: the full-absorption comparison alone would have outsourced everything.

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Common pitfalls and how to avoid them

Comparing a supplier price with a full-absorption internal cost.Separate avoidable costs from allocated overhead, and show what happens to the remaining products' absorbed cost if the volume leaves.
Ignoring the hidden buy costs: logistics, inspection, supplier management, inventory.Build a total landed cost for the buy option and include the cost of switching back.
Deciding once and never revisiting.Set a review date and trigger conditions such as volume change, capacity change or new supplier capability.
Outsourcing the parts that carry process know-how or IP.Score strategic criteria explicitly and protect the families that differentiate the product.

Frequently asked questions

What costs should be included in a make-or-buy analysis?

For make: material, direct labor, machine time, the overhead that would actually change, quality costs, capital and inventory. For buy: price, freight, duties, incoming inspection, supplier management, inventory carrying cost, tooling, switching risk and exit cost. The key distinction is between avoidable costs, which disappear with the decision, and allocated costs, which stay and get spread over the remaining products.

Why does transaction cost economics matter for make or buy?

It explains that markets are not free to use. Searching, contracting, monitoring and enforcing agreements have costs, and they rise when the part is highly specific to your product, when requirements are uncertain or when transactions are frequent and complex. In those cases in-house production can be cheaper overall even when a supplier's unit price is lower.

How often should make-or-buy decisions be reviewed?

Review them on a fixed cycle, typically annually, and whenever a trigger occurs: a significant volume change, a capacity constraint, a major capital decision on the equipment involved, or a new supplier capability. The right answer at 500 units a year can be wrong at 5,000.

Origin

Make-or-buy analysis — procurement and vertical-integration economics (Coase, 1937; transaction cost lineage).

Used in these playbooks

Sourcing cost-push month 1 month

One month focused on bought-in cost: pareto the spend, substitute materials, settle make-or-buy and lock a cost-down curve with key suppliers.

Related methods

More in “Evaluate”

Grade the estimates and price the risks before deciding.