Cost has relevance in make or buy decisions when all other factors are equal, or else reasonable cost estimates of the variations should be included to make up for any inequality.
Let us consider quality, quantity and service factors to be equal. Then the decision of make or buy rests on a comparison between a known cost and an estimated unknown cost. The known cost is the price charged by the vendor, and the unknown estimated cost is the cost of making. If there is negligible difference between the two costs, the item should be purchased. In most cases, a known cost is rather more reliable than a slightly lower estimated cost.
How is the cost of making estimated? It is a skilled job and the estimate is more reliable when it is calculated with skill and care. When the item is smaller, value wise and quantity wise, the task of accurate estimation becomes difficult.
The estimation of the cost accurately becomes difficult when overhead costs are to be allocated on an item that is made in the plant from the materials and on the machines being used for other items. If the item is such as it stands out in a class by itself, the overheads are easy to allocate.
Then there is a problem of the current level of production in the plant. A plant operating at or near capacity a different cost sheet of the item now being purchased than a plant having idle capacity would give. Idle capacity results in a high ratio of fixed costs to total costs. Therefore, additional output can be obtained with only a nominal increase in total cost. On the other hand, a form operating at full capacity gives additional output at substantially increased costs.
A plant with excess capacity can increase production by merely adding incremental costs that are variable in nature. A plant working at capacity, however can give additional output only by increasing its capacity, thereby adding incremental costs of both fixed an variable nature, BEC (break even chart) would make the point clear.
A firm raises its output from 100 to 110% incurring thereby incremental costs of Rs 30 (Rs 120 to Rs 150 per unit) as a result of increase in fixed and variable costs. However, the same firm could have raised its output from 70 to 80% and incurred incremental costs of only Rs 8 per unit (Rs 91 to Rs 98) since the latter output range keeps fixed costs constant and increases merely direct costs.
When the plant works below capacity, the cost of making should be determined by dividing the estimated volume into the increased variable costs. The purchase decision then would be taken for the item if its unit purchase cost equals or is less than the unit increase is variable costs. At any higher price, the decision is in favor of making, because it would be contributing something towards overhead costs.
The plant operating at capacity presents a different situation. The options now open are to expand the facilities or go in for an outside purchase. In such a situation it is right on the part of the company to purchase from outsider at any price less than the unit total costs making the item. If the requirement is meager, the buyer may even be justified in paying an enhanced price rather than committing funds to expansion of facilities that may be left party utilized and partly unutilized.
The above analysis of cost considerations, though apparently simple, involves difficult assumptions in practical situations. The time element looms large in any decision. A firm having a plant operating at 70% of capacity errs in changing from buying to making if projected sales of product line will require capacity production in a few years. Besides this, there is a difficult problem of classifying costs in or fixed and variable expenses, exclusive of each other, whereas in practice many costs are partly fixed and partly variable.