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Strategic Cost Management · Decisions involving Alternative Choices

Make or Buy Decision: Formula, Method and Solved Examples

Updated 11 October 2026 · Fact-checked

A make or buy decision compares the relevant cost of making a component in-house with the price of buying it from outside. Include only avoidable costs and the opportunity cost of any capacity used. Choose the cheaper option. If capacity is limited, compare the extra cost of buying per unit of scarce resource saved.

Understand Make or Buy Decisions

A make or buy decision asks one question: is it cheaper for the firm to produce a part itself, or to buy it from a supplier? The same logic applies to outsourcing a service.

The decision uses relevant costs. These are future costs that change depending on the choice. If you buy, you save the costs that disappear. If you make, you avoid the purchase price. Sunk costs and unavoidable fixed costs do not change, so ignore them.

So the comparison is: relevant cost of making (variable cost plus any avoidable fixed cost plus opportunity cost) against purchase price (plus any extra costs of buying, such as freight or inspection). Allocated fixed overhead that continues either way is not relevant.

Capacity decides how you treat opportunity cost. If you have spare capacity, the resources used have no alternative use, so the opportunity cost is zero. If capacity is fully used, making the part means giving up something else, usually contribution from another product. That lost contribution is an opportunity cost and must be added to the cost of making.

When capacity is limited and several components can be bought, you cannot simply compare unit costs. Rank the components by the extra cost of buying per unit of the scarce resource (for example per machine hour). Make the ones with the highest ratio in-house, and buy the ones with the lowest ratio. Also check non-financial factors: quality, supplier reliability, confidentiality and long-term dependence.

Key rules to remember

Relevant cost of making
Relevant cost of making = Variable cost + Avoidable fixed cost + Opportunity cost
Opportunity cost is zero if the capacity is idle. Exclude unavoidable fixed cost and sunk cost.
Relevant cost of buying
Relevant cost of buying = Purchase price + Other incremental buying costs − Any saleable value of released resources
Add freight, inspection and ordering cost. Subtract rent or sale proceeds from released capacity only if it is actually earned.
Decision rule
Make if relevant cost of making < relevant cost of buying; otherwise buy
Check qualitative factors before the final recommendation.
Limited capacity ranking
Extra cost of buying per unit of scarce resource = (Buy price − Relevant variable cost of making) ÷ Scarce resource units per unit of component
Make components with the highest ratio first, until the scarce resource runs out.
Opportunity cost of capacity
Opportunity cost = Contribution lost from the next best use of the capacity
Use contribution, not profit, because fixed costs continue either way.

How to solve Make or Buy Decisions questions

Use this method for any make or buy question, whether capacity is spare, full or limited.

  1. 1Read the data and list the cost of making per unit, then split it into variable, avoidable fixed and unavoidable fixed cost.
  2. 2Discard sunk costs and fixed costs that continue whichever option you choose.
  3. 3Decide whether capacity is spare or fully used. If it is spare, opportunity cost is nil. If it is full, find the best alternative use and its contribution.
  4. 4Compute the relevant cost of making per unit (or in total) including any opportunity cost.
  5. 5Compute the relevant cost of buying: price plus extra buying costs, less any benefit from released resources.
  6. 6If several components compete for limited capacity, compute the extra cost of buying per scarce resource unit, rank, and allocate capacity to the highest ratio first.
  7. 7Compare totals, state the saving or extra cost, and give a clear recommendation.
  8. 8Add one or two qualitative points such as quality, supply risk and long-term effects.

Quickest way: Relevant cost table with a one-line saving

When to use it: Use when time is short and the question gives a full cost sheet with a buy price.

  1. Write only two columns: Make and Buy, with total cost for the given volume.
  2. Under Make, pick up variable cost and avoidable fixed cost. Add lost contribution if capacity is full.
  3. Under Buy, write price × units plus extra buying costs.
  4. Subtract the smaller from the larger to get the saving, and write the decision in one line.
  5. For limited capacity, compute (buy price − variable make cost) ÷ hours per unit for each part and rank.

Common mistakes in Make or Buy Decisions

  • Comparing the buy price with the full absorption cost of making.

    The cost sheet shows total cost per unit, and students use it without checking which parts will actually change.

    Fix: Remove fixed overhead that continues even if you buy. Keep only avoidable costs.

  • Ignoring opportunity cost when capacity is fully used.

    Students focus on the cost sheet and forget what the capacity could earn elsewhere.

    Fix: Read the capacity statement first. If it is full, add the contribution lost from the next best use.

  • Adding opportunity cost when capacity is idle.

    Students apply the rule mechanically after learning it.

    Fix: If the capacity has no other use, the opportunity cost is zero. Do not add anything.

  • Ranking components by saving per unit instead of per scarce resource unit.

    Per-unit saving looks like the natural comparison.

    Fix: Divide the extra cost of buying by the scarce resource used per unit, then rank on that ratio.

  • Forgetting the extra costs of buying or the rent from released space.

    Students stop at the supplier's price.

    Fix: Scan the question for freight, inspection, and any rent or sale value of released assets, and include them.

  • Giving a number but no recommendation.

    Students treat the question as pure arithmetic.

    Fix: End with a clear decision and one line on qualitative factors.

Worked examples

Example 1

Madhav Auto Ltd makes 10,000 units of component M every year. Cost per unit: direct material ₹40, direct labour ₹30, variable overhead ₹20, fixed overhead ₹25 (of which ₹10 per unit would be saved if production stopped, the rest is unavoidable). A supplier offers to supply M at ₹95 per unit. The capacity released has no alternative use. Should the company buy?

Show the solution
  1. Relevant cost of making per unit = 40 + 30 + 20 + 10 (avoidable fixed) = ₹100.
  2. Unavoidable fixed overhead of ₹15 per unit continues either way, so ignore it.
  3. Capacity has no alternative use, so opportunity cost is nil.
  4. Relevant cost of buying = ₹95 per unit.
  5. Saving per unit by buying = 100 − 95 = ₹5.
  6. Total saving = 5 × 10,000 = ₹50,000.

Answer: Buy the component. The company saves ₹50,000 a year, subject to quality and supply reliability.

Example 2

Kaveri Engineering needs 5,000 units each of parts X and Y. Machine hours are limited to 12,000. Variable cost of making: X ₹60 (2 hours per unit), Y ₹90 (3 hours per unit). Buy prices: X ₹80, Y ₹120. Which parts should it make, and what is the total cost of meeting the demand?

Show the solution
  1. Hours needed to make both = 5,000 × 2 + 5,000 × 3 = 25,000 hours, against 12,000 available. So some parts must be bought.
  2. Extra cost of buying X = 80 − 60 = ₹20 per unit, so ₹20 ÷ 2 = ₹10 per machine hour.
  3. Extra cost of buying Y = 120 − 90 = ₹30 per unit, so ₹30 ÷ 3 = ₹10 per machine hour.
  4. Both ratios are equal at ₹10, so the ranking does not matter for cost. Any mix that uses all 12,000 hours gives the same total.
  5. One such mix with whole units: make 3,000 X (6,000 hours) and 2,000 Y (6,000 hours), which uses all 12,000 hours. Buy 2,000 X and 3,000 Y.
  6. Total cost if all bought = 5,000 × 80 + 5,000 × 120 = 4,00,000 + 6,00,000 = ₹10,00,000.
  7. Saving from making = ₹10 × 12,000 hours = ₹1,20,000.
  8. Total cost = 10,00,000 − 1,20,000 = ₹8,80,000.
  9. Check with the mix: make X 3,000 × 60 = ₹1,80,000; make Y 2,000 × 90 = ₹1,80,000; buy X 2,000 × 80 = ₹1,60,000; buy Y 3,000 × 120 = ₹3,60,000. Total = ₹8,80,000.

Answer: Total minimum cost is ₹8,80,000. Both parts save ₹10 per machine hour, so any mix that uses all 12,000 hours gives the same cost. For example, make 3,000 units of X and 2,000 units of Y, and buy 2,000 units of X and 3,000 units of Y. Choose the mix on quality and supplier risk.

Exam tips

  • Read the capacity sentence first. It decides whether opportunity cost is zero or a lost contribution.
  • Show the split of fixed cost into avoidable and unavoidable. Examiners award marks for this classification.
  • In limited-capacity questions, show the ratio per scarce resource hour for each component, then the ranking table.
  • Always write a one-line recommendation and one qualitative factor. Case-based MCQs often test exactly this judgement.
  • If the question mentions rent, sale of machinery or alternative product, check whether it must be added to the buying side or the making side.

Practice questions from Decisions involving Alternative Choices

Make or Buy Decisions in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Make or Buy Decisions: frequently asked questions

What is the formula for a make or buy decision?

There is no single formula. Compare the relevant cost of making (variable cost, avoidable fixed cost and opportunity cost) with the relevant cost of buying (price plus extra buying costs, less benefits from released resources). Choose the lower.

How do you solve a make or buy problem with limited capacity?

Calculate the extra cost of buying each component per unit of the scarce resource, such as machine hour. Make the components with the highest ratio in-house first until capacity is used, and buy the rest.

Is fixed overhead relevant in a make or buy decision?

Only the part that will be saved if you stop making the item is relevant. Fixed overhead that continues whether you make or buy is irrelevant, even if it appears in the cost sheet.

When is opportunity cost added in make or buy?

Add it when capacity is fully used and making the part means giving up another use. Take the contribution lost from the best alternative. If capacity is idle, opportunity cost is nil.