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Management Accounting · Applications of Marginal Costing in Short Term Decision Making

Make or Buy Decision: Relevant Cost Method for CMA Inter

Updated 10 October 2026 · Fact-checked

A make or buy decision compares the relevant cost of producing a component in-house with the price of buying it. Count only costs that change with the decision: variable cost, avoidable fixed cost and lost opportunity benefit. Choose the cheaper option. If capacity is limited, rank components by extra cost of buying per unit of scarce resource.

Understand Make or Buy Decisions

A firm often needs a component or service. It can make it with its own plant, or buy it from an outside supplier. The make or buy decision asks which option costs the firm less overall.

The key idea is relevant cost. A cost is relevant only if it differs between the two options. Variable cost of making is saved if you buy, so it is relevant. Fixed cost that continues whether you make or buy is not relevant. Fixed cost that can be avoided if you stop making (for example a supervisor you can let go) is relevant.

The full absorbed cost per unit usually misleads. It includes fixed overheads that may not disappear on buying. Comparing the purchase price with absorbed cost can make buying look cheaper when it is not.

There are two situations. If capacity is spare, make unless the buying price is below the relevant cost of making. If capacity is limited, you cannot make everything. Making uses scarce hours, so you must decide which components to make and which to buy. Rank them by how much extra buying costs for each hour of scarce capacity saved. Make the highest-ranked first.

If the capacity freed by buying can be used for another job, the contribution from that job is an opportunity cost of making. Add it to the cost of making. Also consider non-money factors: quality, reliability of supply, secrecy, and long-term dependence on the supplier.

Key rules to remember

Relevant cost of making
Variable cost (material + labour + variable overhead) + avoidable fixed cost + opportunity cost
Exclude unavoidable fixed cost and sunk cost. Add opportunity cost only if freed capacity or resources have an alternative use.
Basic decision rule (spare capacity)
Make if relevant cost of making < purchase price; Buy if purchase price < relevant cost of making
Compare on the same unit basis, or on total cost for the whole volume.
Opportunity cost of freed capacity
Contribution per unit of alternative use × units that could be produced with freed capacity
Use the contribution of the best alternative use only.
Ranking under limited capacity
Extra cost of buying per unit of scarce resource = (Purchase price − Variable cost of making) ÷ Scarce resource per unit
Make the components with the highest ratio first. Buy those with the lowest ratio. Use avoidable fixed cost carefully if it depends on volume.
Total cost comparison
Cost of making all = Relevant cost × units; Cost of buying = Price × units − avoidable fixed cost saved − contribution earned from freed capacity
Use when fixed cost saved only arises if the whole volume is bought. Deducting the contribution from freed capacity on the buying side is the same as adding that opportunity cost to the cost of making. Do not do both.

How to solve Make or Buy Decisions questions

Use this method for any make or buy question, with or without a capacity limit.

  1. 1List the cost of making per unit: direct material, direct labour, variable overhead, and any fixed cost given.
  2. 2Decide which fixed costs are avoidable if you stop making. Drop all unavoidable and apportioned fixed costs. Keep avoidable ones.
  3. 3Check for opportunity cost: can freed capacity, space or labour earn contribution elsewhere? Add it to the cost of making if so.
  4. 4Check capacity. If there is no limit, compare the relevant cost of making with the buying price and pick the lower.
  5. 5If capacity is limited, compute the extra cost of buying per unit for each component, divide by the scarce resource per unit, and rank.
  6. 6Allocate scarce hours to the highest-ranked components first until hours run out. Buy the rest.
  7. 7Compute the total relevant cost or the total saving for the final plan, and state the decision clearly.
  8. 8Add a one-line note on qualitative factors such as quality, supply reliability and dependence on the supplier.

Quickest way: Variable cost versus price, then rank per hour

When to use it: Use it when the question gives several components, a limited number of machine or labour hours, and a market price for each.

  1. Write one row per component: variable cost to make, purchase price, hours per unit.
  2. Compute the extra cost of buying: price minus variable cost.
  3. Divide by hours per unit. This is the penalty per hour saved by buying.
  4. Rank from highest to lowest. Highest means make first.
  5. Fill the hours available in rank order. A partial component can be made only if the question allows it.
  6. Buy the remainder and total the cost.

Common mistakes in Make or Buy Decisions

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

    The cost sheet shows total cost and it looks like the obvious figure to use.

    Fix: Use only variable cost and avoidable fixed cost. Remove apportioned fixed overheads that continue anyway.

  • Ignoring the opportunity cost of capacity that buying would free.

    Students stop once they have compared cost with price.

    Fix: Read the question for alternative uses of the plant or space. Add the contribution forgone to the cost of making.

  • Ranking components by the lowest cost difference per unit rather than per unit of scarce resource.

    Per-unit differences are easy to see, and the hours column gets overlooked.

    Fix: Always divide the extra cost of buying by the scarce hours per unit before ranking.

  • Treating all fixed cost as avoidable when buying.

    Students assume that buying shuts the activity down entirely.

    Fix: Include only the fixed cost that the question says will be saved, such as a specific supervisor's salary or rent that can be avoided.

  • Giving a numerical answer without a decision statement.

    Students stop after the calculation.

    Fix: Write the decision in words, give the saving in rupees and add one qualitative point.

Worked examples

Example 1

Shree Auto Ltd makes 10,000 units of component X each year. Cost per unit: direct material ₹40, direct labour ₹30, variable overhead ₹20, fixed overhead absorbed ₹25. Of the fixed overhead, ₹5 per unit is avoidable if X is bought. A supplier offers X at ₹90 per unit. There is no alternative use of the capacity. Should Shree Auto make or buy?

Show the solution
  1. Variable cost per unit = 40 + 30 + 20 = ₹90.
  2. Avoidable fixed cost per unit = ₹5.
  3. Relevant cost of making = 90 + 5 = ₹95 per unit.
  4. Unavoidable fixed overhead = 25 − 5 = ₹20 per unit. It continues in both options, so it is ignored.
  5. Purchase price = ₹90 per unit, which is less than ₹95.
  6. Saving by buying = (95 − 90) × 10,000 = ₹50,000.

Answer: Buy X from the supplier. It saves ₹50,000 a year, subject to quality and supply reliability.

Example 2

Kaveri Engineering needs 1,000 units each of components A, B and C. Machine hours available are 4,000. Data per unit: A: variable cost ₹60, buying price ₹75, 2 hours. B: variable cost ₹80, buying price ₹110, 3 hours. C: variable cost ₹50, buying price ₹56, 1 hour. Decide which components to make and which to buy, and find the total relevant cost.

Show the solution
  1. Total hours to make all = 1,000 × (2 + 3 + 1) = 6,000, which exceeds 4,000. Capacity is limited.
  2. Extra cost of buying per unit: A = 75 − 60 = ₹15; B = 110 − 80 = ₹30; C = 56 − 50 = ₹6.
  3. Per machine hour: A = 15 ÷ 2 = ₹7.50; B = 30 ÷ 3 = ₹10; C = 6 ÷ 1 = ₹6.
  4. Ranking: B (₹10), A (₹7.50), C (₹6).
  5. Make B first: 1,000 × 3 = 3,000 hours. Remaining = 1,000 hours.
  6. Make A next: 1,000 hours allow 500 units of A. Buy the other 500 units of A.
  7. Buy all 1,000 units of C.
  8. Cost: B made = 1,000 × 80 = ₹80,000. A made = 500 × 60 = ₹30,000. A bought = 500 × 75 = ₹37,500. C bought = 1,000 × 56 = ₹56,000.
  9. Total = 80,000 + 30,000 + 37,500 + 56,000 = ₹2,03,500.

Answer: Make all 1,000 units of B and 500 units of A. Buy 500 units of A and all 1,000 units of C. Total relevant cost is ₹2,03,500.

Exam tips

  • Underline the words 'avoidable', 'continue', 'alternative use' and 'limited hours' in the question. They decide which costs are relevant.
  • Show a short table of relevant costs. Examiners give step marks for correct inclusion and exclusion of fixed cost.
  • In limited-capacity problems, show the per-hour ranking column clearly even if your arithmetic slips later.
  • In MCQs, check first whether the fixed cost given is avoidable. A wrong treatment of fixed cost is the usual trap.
  • End written answers with the decision, the rupee saving and one qualitative factor.

Practice questions from Applications of Marginal Costing in Short Term Decision Making

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 costs are relevant in a make or buy decision?

Relevant costs are future costs that differ between making and buying. They include variable cost, avoidable fixed cost and the opportunity cost of capacity. Sunk cost and unavoidable fixed cost are ignored.

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

Find the extra cost of buying each component over its variable cost of making. Divide by the scarce resource used per unit. Make the components with the highest figure first until the capacity is used, and buy the rest.

Should I use absorbed cost in a make or buy decision?

No. Absorbed cost includes fixed overhead that often continues even if you buy. Use variable cost plus only the fixed cost that can be avoided.

What non-financial factors affect make or buy?

Quality control, reliability and timing of supply, secrecy of design, supplier dependence, labour relations and the firm's long-term strategy all matter. Mention at least one in written answers.