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Goods and Services Tax (GST) and Corporate Tax Planning · Tax Planning and Managerial Decisions

Make or Buy Decision in Corporate Tax Planning

Updated 11 October 2026 · Fact-checked

A make or buy decision compares the cost of producing a part in-house with the cost of buying it from outside. You bring both to an after-tax basis, include only relevant (avoidable) costs, and choose the lower after-tax net cost. Tax shields on deductible costs and depreciation change the answer.

Understand Make or Buy Decision

A company needs a component or service. It can make it using its own plant, labour and materials, or buy it from a supplier. The choice looks like a pure cost question, but tax changes the real cost of each route.

Most costs of making and buying are business expenses. They reduce taxable profit, so the government bears part of them. A ₹100 expense at a 25% tax rate costs the company only ₹75 after tax. This saving is the tax shield.

So you compare after-tax cash costs, not book costs. Only relevant costs count: costs that change with the decision. Fixed overheads that continue whether you make or buy are ignored. Costs that disappear if you buy, such as variable cost, avoidable fixed cost and saleable plant, are included.

If making needs new machinery, add the cost of the asset and subtract the tax saving from depreciation. If buying frees capacity or releases an asset for sale, count the benefit. Also check non-tax factors such as quality, supply risk and timing, but the exam answer rests on the numbers.

The tax rate you use must come from the question. Do not assume one. If the question gives an effective rate, use it as given.

Key rules to remember

After-tax cost of a deductible expense
After-tax cost = Pre-tax cost × (1 − t)
t is the tax rate given in the question, as a decimal. Use it only for costs allowed as a deduction.
Tax shield on depreciation
Tax shield = Depreciation × t
Depreciation is not a cash cost. It matters only through the tax saving. Use the depreciation figure the question supplies.
Relevant cost of making
Make cost = Variable cost + Avoidable fixed cost + Opportunity cost (if any)
Leave out unavoidable fixed overheads. They are the same under both options.
Decision rule
Choose the option with the lower after-tax net cost
Compare per unit or in total, but keep the same basis for both options.
Indifference point
Break-even quantity = Extra fixed cost of making ÷ (Buy price − Variable make cost), with both parts on the same tax basis
Use it only when the buy price is higher than the variable cost of making. If it is not, making is never cheaper at any quantity. When that condition holds, making is cheaper above this quantity and buying is cheaper below it. The extra fixed cost of making must include avoidable fixed cost and the cost of any asset, net of the depreciation tax shield. Put the numerator and denominator on the same basis, either both pre-tax or both after-tax. Applies when the fixed cost is incurred only if you make.

How to solve Make or Buy Decision questions

Use this order for any make or buy question. It keeps you from mixing pre-tax and post-tax numbers.

  1. 1List the facts for each option: units, variable cost per unit, fixed costs, buy price, asset cost, depreciation and tax rate.
  2. 2Pick out the relevant costs. Strike off fixed costs that continue under both options.
  3. 3Apply the tax rate to every deductible cash cost to get the after-tax cost.
  4. 4Add the tax shield on depreciation as a reduction of the cost of making. Do not treat depreciation itself as cash.
  5. 5Add any capital outlay and any sale proceeds of assets if the question gives them, with their tax effect as stated.
  6. 6Total the after-tax cost of each option on the same basis, per unit or in total.
  7. 7State the lower-cost option and the saving in rupees.
  8. 8Add one line on non-tax factors such as quality and supply reliability.

Quickest way: Net-of-tax comparison shortcut

When to use it: Use it only when both costs are fully deductible, the same positive tax rate applies to both in the same years, cash timing is the same, and the company has enough profit to absorb the deduction. Then the tax factor (1 − t) applies to both sides equally.

  1. Compute pre-tax relevant cost of making and of buying.
  2. If no capital outlay or depreciation is involved, and both options are taxed at the same rate in the same years with tax payable (profit is enough to absorb the deduction), compare them directly. The lower pre-tax cost is also the lower after-tax cost.
  3. If depreciation or an asset purchase is involved, or the tax rate or timing differs between the options, convert to after-tax figures. Do not use the shortcut.
  4. Still write the after-tax figures if the question asks for them. Examiners give marks for the steps.

Common mistakes in Make or Buy Decision

  • Including unavoidable fixed overheads in the cost of making

    Students copy the full cost sheet without asking which costs change.

    Fix: Ask of each cost: does it go away if we buy? If not, leave it out.

  • Comparing a pre-tax make cost with an after-tax buy cost

    Tax is applied to one side and forgotten on the other.

    Fix: Put both options on an after-tax basis before you compare.

  • Treating depreciation as a cash outflow

    It appears in the cost list, so it looks like a cost.

    Fix: Use depreciation only for its tax shield: depreciation × t.

  • Ignoring the purchase cost of the asset needed to make

    Students focus on running costs.

    Fix: Include the capital outlay, and then subtract the depreciation tax shield.

  • Using a tax rate not given in the question

    Students assume a standard company rate from memory.

    Fix: Use the rate stated in the question. If none is given, state your assumed rate clearly.

  • Stopping at the number without a recommendation

    Students treat it as pure arithmetic.

    Fix: End with the decision, the saving, and a brief note on non-tax factors.

Worked examples

Example 1

Raj Components Ltd needs 10,000 units of a part a year. Making: variable cost ₹80 per unit and avoidable fixed cost ₹2,00,000 a year. Buying: ₹100 per unit. Tax rate 25%. All costs are deductible. Should it make or buy?

Show the solution
  1. Pre-tax cost of making = 10,000 × ₹80 + ₹2,00,000 = ₹8,00,000 + ₹2,00,000 = ₹10,00,000.
  2. After-tax cost of making = ₹10,00,000 × (1 − 0.25) = ₹7,50,000.
  3. Pre-tax cost of buying = 10,000 × ₹100 = ₹10,00,000.
  4. After-tax cost of buying = ₹10,00,000 × 0.75 = ₹7,50,000.
  5. Both options cost the same, so the choice rests on non-tax factors.

Answer: After-tax cost is ₹7,50,000 under both options. The company is indifferent on cost. It should decide on quality, supply security and use of capacity.

Example 2

Sharma Foods Ltd needs 5,000 units a year for 5 years. Buying costs ₹150 per unit. Making needs a machine costing ₹5,00,000 and variable cost of ₹110 per unit. Depreciation is ₹1,00,000 a year. The machine has nil residual value after 5 years, and depreciation is the only tax deduction for its cost. Tax rate 25%. Ignore the time value of money. Compare the total 5-year after-tax costs.

Show the solution
  1. Buy: annual pre-tax cost = 5,000 × ₹150 = ₹7,50,000. After tax = ₹7,50,000 × 0.75 = ₹5,62,500.
  2. Buy: 5-year after-tax cost = ₹5,62,500 × 5 = ₹28,12,500.
  3. Make: annual variable cost = 5,000 × ₹110 = ₹5,50,000. After tax = ₹5,50,000 × 0.75 = ₹4,12,500.
  4. Make: 5-year after-tax running cost = ₹4,12,500 × 5 = ₹20,62,500.
  5. Depreciation tax shield per year = ₹1,00,000 × 0.25 = ₹25,000. Over 5 years = ₹1,25,000.
  6. Make: total = ₹5,00,000 (machine outlay at the start, nil residual value) + ₹20,62,500 − ₹1,25,000 = ₹24,37,500.
  7. Saving from making = ₹28,12,500 − ₹24,37,500 = ₹3,75,000.

Answer: Making costs ₹24,37,500 against ₹28,12,500 for buying. Making saves ₹3,75,000 over 5 years on an after-tax basis, ignoring the time value of money and assuming nil residual value.

Exam tips

  • Write the tax rate and your assumptions in the first line. Marks follow the steps.
  • Show a clear table of relevant costs for each option. A tidy layout helps the examiner follow you.
  • Always finish with a recommendation and a line on non-tax factors. The paper is descriptive and case-based.
  • If the question mentions present value, discount the after-tax cash flows. Do not discount if it says to ignore time value.
  • Read which costs are fixed and whether they are avoidable before you start any calculation.

Practice questions from Tax Planning and Managerial Decisions

Make or Buy Decision 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 Decision: frequently asked questions

What is a make or buy decision in tax planning?

It is the choice between producing a part in-house and buying it from a supplier. You compare the after-tax cost of each route. The lower after-tax cost wins, subject to non-tax factors.

Which costs are relevant in a make or buy problem?

Only costs that change with the decision are relevant. These include variable cost, avoidable fixed cost and any opportunity cost. Fixed overheads that continue either way are ignored.

How does depreciation affect the decision?

Depreciation is not a cash cost. It reduces taxable profit, so it gives a tax saving equal to depreciation × tax rate. That saving lowers the cost of making.

Do I need to discount cash flows?

Only if the question asks for present value or gives a discount rate. If it says to ignore the time value of money, simply total the after-tax costs.