This outcome asks you to decide whether to make a product in-house or buy it in, using relevant costs and sensible non-financial judgment. The examiner likes it because it tests whether you can strip out unavoidable costs and spot opportunity costs, instead of just comparing the quote with full cost.
The rule
Compare the quote with the relevant cost of making: the extra cash costs that disappear if you buy. Include variable costs and avoidable fixed costs, and exclude fixed costs that continue either way. If capacity is limited, add the contribution forgone on the next best use of the resources as an opportunity cost. Then consider qualitative factors such as quality control, reliability of supply, confidentiality and dependence on one supplier. Outsourcing never transfers all the risk to the supplier.
Worked example
A firm makes a pack at a full cost of $17: materials $6, labor $4, variable overhead $2 and absorbed fixed overhead $5. 60% of the fixed overhead is unavoidable. A supplier quotes $15.
Relevant cost of making = 6 + 4 + 2 + (40% x 5 = 2) = $14.
The $3 of unavoidable fixed overhead (60% x $5) continues whether the firm makes or buys, so it is ignored.
Making ($14) is $1 per pack cheaper than buying ($15).
Now suppose there is no spare capacity. Each unit uses 2 machine hours that could earn $9 contribution per hour elsewhere, and the variable cost is $18 with a quote of $32.
Opportunity cost = 2 x $9 = $18.
Relevant cost of making = 18 + 18 = $36.
Buying at $32 saves $4 per unit, so buy.
Remember: absorbed fixed overhead is relevant only to the extent that it is avoidable, and when capacity is short you must add the contribution forgone per unit before comparing with the quote.
Where candidates lose marks
Using the full absorbed cost of $17 and so including fixed overhead that continues whether you make or buy.
Dropping all fixed overhead and missing the avoidable part that would be saved by buying.
Comparing variable cost with the quote when there is no spare capacity, so ignoring the opportunity cost and wrongly choosing to make.
Using only one machine hour of opportunity cost when each unit uses two.
Claiming that outsourcing transfers all risk to the supplier, when supplier failure still hits the buyer's production and reputation.
Try it: 4 questions
Pawcare Vets Co makes its own sterile surgical packs and has received a supplier quote of $15 per pack. The full cost per pack is: materials $6, labour $4, variable overhead $2 and absorbed fixed overhead $5, a total of $17. Of the absorbed fixed overhead, 60% is unavoidable and would continue even if the practice stopped making the packs. What is the relevant cost per pack of making, to compare with the quote?
Answer: B. In a make-or-buy decision only costs that differ between the options are relevant. Relevant cost of making = materials $6 + labour $4 + variable overhead $2 + avoidable fixed overhead (40% x $5 = $2) = $14. This is below the $15 quote, so making is cheaper. $17 is wrong because it includes the $3 of absorbed fixed overhead that continues whether the practice makes or buys. $12 is wrong because it drops all fixed overhead, including the $2 that would be saved. $10 is wrong because it counts only materials and labour and omits the variable overhead and the avoidable fixed overhead.
Axlefit Co, a car parts maker, is considering outsourcing the manufacture of brake components. Which of the following statements about the qualitative factors involved is NOT true?
Answer: D. The fourth statement is not true. Outsourcing does not remove risk: if the supplier delivers late or supplies defective parts, the buyer still faces production stoppages, lost sales and reputational damage with its own customers, so supplier failure must be assessed. The other three statements are true. Quality control is harder when production is outside the firm. Dependence on one supplier creates supply risk. Confidential designs are exposed when shared.
Pixelforge Co, a mobile game studio, has no spare capacity on its 3D printers. It makes collectible display stands (component X) in-house at a variable cost of $18 per unit, and each stand uses 2 machine hours. Those hours could instead be used to make Y, collectible figurines, which earn a contribution of $9 per machine hour. A supplier quotes $32 per stand. Which TWO of the following statements are correct?
Select the two that apply (each shows on its own).
Answer: A, C. With no spare capacity, making X means giving up contribution from Y. Opportunity cost = 2 hours x $9 = $18. Relevant cost of making X = variable cost $18 + opportunity cost $18 = $36 per unit. The quote is $32, so buying saves $4 per unit and Pixelforge Co should buy. The $18 option ignores the contribution forgone on Y. Recommending make because $18 < $32 makes the same error and wrongly favours making. The $27 option uses only one machine hour ($9) of opportunity cost instead of two.
Vet Care Co has a temporary peak in demand for appointments that exceeds its normal capacity for the next three months. The practice is considering (1) paying existing nurses and vets overtime, (2) subcontracting some appointments to a neighbouring practice at a fixed fee per appointment, or (3) doing nothing and turning work away. The costs of each option have been estimated, and some of the practice's fixed costs, such as rent and equipment depreciation, will be the same under all three options. Which of the following is the most appropriate method for comparing the options?
Answer: B. Rule: in a short-term decision such as this one, only future cash flows that differ between the alternatives are relevant. Each option should be assessed by its incremental revenue less its incremental cost (its contribution), measured against the do-nothing baseline. Fixed costs that are the same under every option are irrelevant.
Correct option: comparing incremental revenues and costs against the do-nothing baseline. This captures the extra income earned, the extra overtime or subcontract cost, and the lost income if work is turned away.
Why the others are wrong: - Full absorption cost per appointment: this includes apportioned fixed overheads such as rent and depreciation, which do not change with the decision and so are irrelevant. It is the trap answer. - Average cost per appointment: this also blends in unchanged fixed costs, and a low average cost does not show which option adds the most profit. - Total costs, ignoring revenue: the option with the lowest cost may be doing nothing, which earns no income. Revenue differences must be included, and unchanged fixed costs excluded.
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What costs are relevant in a make-or-buy decision?
Only future cash costs that differ between making and buying: variable costs, avoidable fixed costs and any opportunity cost. Unavoidable fixed costs are ignored because they are incurred either way.
How do you treat scarce capacity in a make-or-buy decision?
If making uses resources that have another profitable use, add the contribution forgone to the variable cost of making. For example, 2 hours at $9 contribution per hour adds $18 per unit. Compare the total with the supplier's price.
What qualitative factors affect make-or-buy decisions?
The main ones are control over quality, reliability and risk of supply failure, dependence on a single supplier, and confidentiality of designs. Outsourcing does not remove risk, because supplier failure still harms the buyer.