Buy or Produce Internally? A Guide for Manufacturing Businesses

Imagine you own GulfTech, a mid-sized company that manufactures high-quality electronic components for industrial machines. Business is growing, and you've recently developed a new product: a specialized microchip (hopefully we can do that one day!), that enhances machine efficiency. However, you're facing a big decision—should you manufacture this chip in-house or buy it from an external supplier?

This question isn't just about cost—it's about strategy, control, quality, and long-term financial health. In this article, we'll break down the decision-making process using real-life examples, relevant cost analysis, and storytelling to ensure you grasp each concept step by step.

The Dilemma: Buying vs. Producing Internally

GulfTech’s engineering team is excited about manufacturing the chip themselves. They believe it will give the company more control over quality and supply chain efficiency. But the finance team warns that setting up production could be expensive and might strain resources. Meanwhile, an external supplier, ChinaMicroSource Ltd., has offered to sell the chips for $32 per unit.

You, as the business owner, must decide:

1. Should you produce the chip in-house?
2. Should you buy from ChinaMicroSource Ltd.?
3. What hidden costs and strategic factors should you consider?

Let’s go through this decision step by step using relevant cost analysis.

Step 1: Understanding Relevant Costs

In managerial accounting, relevant costs are those that will change depending on the decision you make. Sunk costs (costs already incurred) should be ignored, while only future costs that vary between the options should be considered.

Breaking Down the Costs

Option 1: Producing In-House

To manufacture the chip internally, AlfaTech would incur the following costs per unit:

• Direct Materials: $12
• Direct Labor: $8
• Variable Overhead (electricity, small tools, etc.): $5
• Fixed Costs (Equipment Depreciation, Maintenance, etc.): $10

Thus, the total cost per unit for in-house production is:

Total?Internal?Cost?per?Unit=12+8+5+10=$35

This is $3 more per unit than buying from ChinaMicroSource Ltd. ($32 per unit).

Option 2: Buying from MicroSource Ltd.

• Purchase price per unit: $32
• No additional labor, material, or equipment maintenance costs

At first glance, buying the chips seems cheaper. But wait, let’s dig deeper.

Step 2: Evaluating Fixed Costs & Opportunity Costs

Fixed Costs: Relevant or Not?

Fixed costs, like factory rent and equipment depreciation, stay the same regardless of production volume. Since these costs will be incurred whether or not you produce the chip, they should be ignored in the short-term decision-making process.

If we exclude the fixed cost of $10 per unit, the revised cost of in-house production is:

Revised?Internal?Cost=12+8+5=$25

Now, manufacturing the chip in-house looks cheaper than buying it for $32!

However, this only works if you already have the equipment and factory space available. If GulfTech needs to invest in new equipment just for this chip, the depreciation of that new machine would become a relevant cost.

Step 3: Strategic Considerations Beyond Cost

Cost alone doesn’t determine the best decision. You also need to consider:

1. Quality & Control

If GulfTech manufactures the chip, they control the quality and can ensure it meets their standards. If they buy from a supplier, they risk delays, defects, or price increases in the future.

2. Capacity & Utilization

Does GulfTech have extra production capacity? If the factory is already running at full capacity, making the chip internally could mean reducing production of other profitable products. In that case, outsourcing might make sense.

3. Hidden Supplier Costs

Suppliers often have minimum order quantities (MOQ). If ChinaMicroSource Ltd. requires a minimum order of 10,000 units per year, but GulfTech only needs 6,000 units, they’ll end up paying for excess inventory or storage costs.

Step 4: The Final Decision – Let’s Do the Math

Let’s assume:

• GulfTech needs 6,000 chips per year
• ChinaMicroSource Ltd. has a MOQ of 10,000 units
• If buying, excess 4,000 units will add $6 per unit in inventory holding costs

Scenario A: Buying from ChinaMicroSource Ltd.

Total?Cost=(Purchase?Price+Storage?Cost)×Quantity

=(32+6)×6,000=38×6,000=$228,000

Scenario B: Producing In-House

Total?Cost=25×6,000=$150,000

At first glance, producing in-house saves $78,000 per year. But if new equipment is needed at a cost of $200,000, depreciated over 5 years, that adds:

Annual?Depreciation?Cost=200,000÷5=$40,000

So the revised total cost for in-house production:

150,000+40,000=$190,000

Still, producing in-house is cheaper by $38,000 per year.

Step 5: Making the Decision

• Short-term: If GulfTech needs the chips immediately, buying might be smarter.
• Long-term: Producing in-house saves money over five years and provides more control.
• If equipment purchase is needed:

The breakeven is reached in about 5.3 years ($200,000 / div 38,000 "savings"), so if GulfTech expects to keep producing the chip long-term, making it in-house is the better move.

Final thoughts for business leaders

1. Ignore Sunk Costs & Focus on Relevant Costs – Fixed costs matter only if they change based on your decision.
2. Look Beyond Per-Unit Price – Factor in inventory holding costs, MOQ, and hidden supplier risks.
3. Consider Capacity Utilization – If you have unused resources, producing in-house might be better.
4. Think Long-Term – A higher short-term cost may lead to greater savings in the long run.

Next time you face a "Buy or Produce" decision, follow this structured approach to make a profitable and strategic choice for your business!

To learn more how to proceed in such situations: reach out to us we can help you make the finance work for your best decision making.

Whatsapp:

https://wa.me/971509044979

Email:

[email protected]

?