Make-or-Buy Decisions: The Relevant Cost Framework With Full Worked Examples

What Relevant Costs Are

Relevant costs are future costs that differ between alternatives. Two conditions must both be met: the cost must be incurred in the future (sunk costs — already spent — are never relevant) and the cost must differ between the alternatives being compared (costs that are the same regardless of which option is chosen do not affect the decision). Applying this filter rigorously is the entire skill in relevant cost analysis.

Relevant cost analysis is also called incremental analysis or differential analysis because it focuses on the incremental (differential) costs and revenues between alternatives. This concept applies to multiple decision types: make-or-buy, special orders, keep-or-drop a product line, and sell-or-process-further decisions. The full CVP and contribution margin framework is explored in the contribution margin guide.

Sunk Costs and Allocated Fixed Costs: Ignore Both

Sunk costs are amounts already spent and irrecoverable — they are the same under every future alternative and therefore irrelevant. The original cost of equipment being replaced, research costs already expended on a project, and past losses are sunk. Including them distorts the analysis and leads to the "sunk cost fallacy" — continuing a bad decision to justify past spending.

Allocated fixed costs — overhead allocated to a product through activity-based costing or traditional allocation — are also typically irrelevant in make-or-buy decisions. If the fixed cost (factory rent, supervisor salary) will continue regardless of whether a component is made internally or purchased externally, it does not affect the decision. Only avoidable fixed costs — those that would actually disappear if production stopped — are relevant.

Make or Buy With Idle Capacity

Scenario: Ridgeway Manufacturing currently makes Part #47, which goes into 10,000 units of its main product annually. An outside supplier offers to supply the part for $28 each. Current internal costs:

At first glance, the total internal cost ($28) equals the supplier price ($28) — no advantage either way. But the relevant comparison uses only avoidable costs:

The $7 of unavoidable allocated fixed overhead is not relevant — it will be incurred whether or not Part #47 is made internally. Including it inflates the apparent internal cost and would lead to the wrong decision.

Make or Buy With Full Capacity

The analysis changes entirely when the company is operating at full capacity. If Ridgeway is at capacity, making Part #47 internally means giving up production of another product. The forgone contribution margin from that displaced product is an opportunity cost that makes internal production more expensive than it appears.

Suppose making Part #47 requires machine hours that could instead produce Product X at a contribution margin of $5 per machine hour, and 3 hours are needed per Part #47. The opportunity cost = 3 hours × $5 = $15 per unit of Part #47.

The same physical cost structure produces the opposite decision once capacity is constrained. This is why make-or-buy analysis must always address the capacity question before reaching a conclusion.

Opportunity Costs in Make-or-Buy

Opportunity costs are benefits foregone by choosing one alternative over another. They are not recorded in the accounting system — they are economic costs that exist only in decision analysis. In make-or-buy, opportunity costs arise from freed-up capacity (what can be done with the resources freed if buying replaces making?) and from unavailable alternatives (what do you give up by committing capacity to internal production?).

If buying outside frees up space for a new revenue-generating activity, the contribution margin of that activity should be added as a benefit of buying. This can tip a borderline decision firmly in favour of outsourcing.

Qualitative Factors That Override the Numbers

Even when the quantitative analysis clearly favours one alternative, qualitative factors can legitimately reverse the decision. Quality and reliability: can the outside supplier consistently meet quality standards and delivery schedules? Dependence risk: does single-sourcing this component create a vulnerability if the supplier fails or raises prices? Strategic considerations: does making this component develop proprietary know-how the company wants to maintain? Labour relations: will outsourcing trigger union grievances or morale problems that impose hidden costs?

Good managerial accounting analysis presents the quantitative recommendation clearly and then explicitly addresses the qualitative factors — rather than ignoring them or burying them in a footnote.

The Decision Framework

1. Identify which costs are avoidable (relevant) if production stops
2. Exclude sunk costs and unavoidable allocated fixed costs
3. Determine whether capacity is constrained — if yes, add opportunity cost of displaced production
4. Compare total relevant cost of making vs total cost of buying
5. Identify and evaluate qualitative factors
6. Make the recommendation with full transparency about assumptions