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Strategic Cost Management · Relevant Cost Analysis

Make or Buy Decision with Relevant Cost

Updated 11 October 2026 · Fact-checked

A make or buy decision compares the relevant cost of producing a part in-house with the price of buying it. Include only future costs that change with the decision: variable cost, avoidable fixed cost and opportunity cost. Ignore unavoidable fixed cost. Choose the lower relevant cost, then check qualitative factors.

Understand Make or Buy Decisions

A firm that needs a component can make it in its own plant or buy it from an outside supplier. The question is simple: which option leaves the firm better off in cash terms?

The trap is the cost sheet. It shows a full cost per unit, including fixed overhead allocations. Much of that overhead continues whether you make or buy. A cost that continues under both options is not relevant. Only differential future costs matter.

So you compare the buy price against the relevant cost of making. This is the variable cost of making, plus any fixed cost that would actually be saved if you stopped making (avoidable fixed cost), plus any opportunity cost of the resources used.

Capacity decides the opportunity cost. If the plant has spare capacity with no alternative use, the opportunity cost is nil. If capacity is limited, buying frees it for another use, and the contribution lost from that use is an opportunity cost of making. With limited capacity, the real question becomes which parts to buy so that the freed capacity earns the most.

Finally, numbers are not the whole answer. Supplier reliability, quality, secrecy, and the risk of the supplier raising prices later can change the recommendation. State them briefly after the calculation.

Key rules to remember

Relevant cost of making (per unit)
Variable cost + avoidable fixed cost per unit + opportunity cost per unit
Use only costs that disappear or arise because of the decision. Unavoidable fixed cost is excluded.
Decision rule (spare capacity)
Make if relevant cost of making < purchase price; buy if purchase price < relevant cost of making
If the two are equal, decide on qualitative factors.
Opportunity cost of capacity
Contribution forgone from the best alternative use of the capacity released or used
Applies when capacity is limited. If buying frees capacity, the contribution earned from it is a benefit of buying.
Extra cost of buying per scarce hour (limited capacity)
(Purchase price − variable cost of making) ÷ scarce resource units per unit of component
Rank components by this figure. Buy those with the lowest extra cost per scarce unit first.
Net advantage of buying
Relevant cost of making − purchase price
Positive means buying saves money. Multiply by volume for the total.

How to solve Make or Buy Decisions questions

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

  1. 1Write down the outside purchase price per unit and the required quantity.
  2. 2List the in-house costs: direct material, direct labour and variable overhead. Treat these as relevant unless the data say otherwise.
  3. 3Examine each fixed cost. Keep only the part that would be saved if production stopped (avoidable). Drop allocated or unavoidable fixed cost.
  4. 4Check capacity. If spare with no other use, opportunity cost is nil. If the capacity can be used elsewhere or is limited, add the contribution forgone.
  5. 5Compute the relevant cost of making and compare it with the purchase price, per unit and in total.
  6. 6If capacity is limited and several components are involved, rank them by extra cost of buying per unit of scarce resource. Buy in that order until the requirement is met.
  7. 7State the recommendation with the rupee saving, then add two or three qualitative points such as quality, supplier reliability and long-term price risk.

Quickest way: Relevant cost versus price in one line

When to use it: Use it for MCQs and for the first pass of a written answer, when you need the answer fast.

  1. Start from the full cost per unit and strike off every cost that continues if you buy.
  2. Add back any opportunity cost, such as contribution lost on other work.
  3. Compare the remainder with the purchase price and pick the lower.
  4. For limited capacity, calculate extra buying cost per scarce hour for each part and buy the part with the smallest figure first.

Common mistakes in Make or Buy Decisions

  • Comparing the buy price with the full absorbed cost per unit.

    The cost sheet is given and the total looks like the cost of making.

    Fix: Remove fixed overhead that continues after buying. Include only avoidable fixed cost.

  • Ignoring the opportunity cost when capacity is limited.

    Students treat the decision as a stand-alone comparison of two prices.

    Fix: Ask what the plant would do with the freed capacity. Add that contribution to the cost of making.

  • Adding opportunity cost when there is spare capacity.

    The habit of always including an opportunity cost line.

    Fix: If the capacity has no alternative use, opportunity cost is nil. Read the capacity statement first.

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

    The absolute difference looks like the natural measure.

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

  • Giving a numerical answer without a recommendation or qualitative points.

    Students stop once the arithmetic is done.

    Fix: Close with a clear decision, the rupee impact and brief non-financial factors.

Worked examples

Example 1

Sundaram Auto Ltd makes 10,000 units of part ZX a year. Cost per unit: direct material ₹120, direct labour ₹80, variable overhead ₹40, fixed overhead absorbed ₹60. Of the fixed overhead, 40% is avoidable if production stops. A supplier offers the part at ₹260 per unit. Spare capacity has no alternative use. Should the firm make or buy?

Show the solution
  1. Variable cost per unit = 120 + 80 + 40 = ₹240.
  2. Avoidable fixed cost per unit = 40% × 60 = ₹24.
  3. Opportunity cost = nil, as capacity is spare with no other use.
  4. Relevant cost of making = 240 + 24 = ₹264 per unit.
  5. Purchase price = ₹260 per unit.
  6. Saving from buying = 264 − 260 = ₹4 per unit. For 10,000 units this is ₹40,000 a year.

Answer: Buy the part. It saves ₹4 per unit, or ₹40,000 a year. The decision is marginal, so check supplier reliability and quality before switching.

Example 2

Kaveri Engineering needs 2,000 units each of parts A and B. Machine hours are limited to 6,000. Part A: variable cost ₹90, 2 machine hours per unit, buy price ₹110. Part B: variable cost ₹150, 3 machine hours per unit, buy price ₹180. Fixed costs are unavoidable. Which part should be made, and which bought, within the machine hours?

Show the solution
  1. Hours needed to make both = 2,000 × 2 + 2,000 × 3 = 4,000 + 6,000 = 10,000. Only 6,000 are available, so some must be bought.
  2. Extra cost of buying A = 110 − 90 = ₹20 per unit. Per machine hour = 20 ÷ 2 = ₹10.
  3. Extra cost of buying B = 180 − 150 = ₹30 per unit. Per machine hour = 30 ÷ 3 = ₹10.
  4. Both are ₹10 per hour, so either ranking gives the same cost.
  5. Hours short = 10,000 − 6,000 = 4,000. Extra cost of buying to cover this = 4,000 × ₹10 = ₹40,000.
  6. Example plan: make all of B (6,000 hours) and buy all of A (2,000 units). Extra cost = 2,000 × 20 = ₹40,000, matching the check.

Answer: Because both parts have the same extra buying cost of ₹10 per machine hour, any mix that uses all 6,000 hours costs the same. For example, make all 2,000 units of B and buy all 2,000 units of A. The extra cost over making everything is ₹40,000. Choose on quality and supplier risk.

Exam tips

  • Read the capacity statement first. It decides whether opportunity cost is nil or must be added.
  • Label every fixed cost as avoidable or unavoidable before computing. Examiners award marks for this classification.
  • In limited capacity questions, show the extra cost per scarce hour for each part. That table earns the method marks.
  • Always end with a recommendation, the rupee figure and at least two qualitative factors.
  • In MCQs, check whether the question gives avoidable fixed cost as a percentage or as a total. Convert it to a per-unit basis before comparing.

Practice questions from Relevant Cost Analysis

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

Why is allocated fixed overhead ignored in make or buy decisions?

If the overhead continues whether you make or buy, it does not change with the decision. Only costs that differ between the options are relevant. Include fixed cost only to the extent it is avoidable.

How do I treat opportunity cost in a make or buy problem?

Ask whether the capacity used for making has another profitable use. If it does, the contribution forgone is added to the cost of making. If the capacity is idle with no alternative use, the opportunity cost is nil.

What if the buy price is equal to the relevant cost of making?

The financial result is the same either way. Decide on qualitative grounds such as quality control, delivery reliability, confidentiality and control over the supply.

How do I solve make or buy with limited capacity for several components?

Find the extra cost of buying each component over making it. Divide by the scarce resource used per unit. Buy the components with the lowest extra cost per scarce unit first, and make the rest within the available capacity.