How companies decide whether to Buy or make a product?
Created on 07 Apr 2020
Wraps up in 5 Min
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Updated on 09 Oct 2020
Decisions to make or buy arise in business when a company must decide whether to produce goods internally or to buy goods externally. This is usually a problem when a company can manufacture material inputs needed for its production operations that are also available for purchase on the market. For example, a computer company may need to decide whether to manufacture circuit boards in-house or purchase them from a supplier.
When analyzing a business decision to make or buy, we should note several factors. The analysis should thoroughly examine all costs related to the manufacture of the product, as well as all costs related to the purchase of the product. This analysis should include both quantitative and qualitative factors. The analysis should also separate the relevant costs from the irrelevant costs and examine only the relevant costs. The analysis should also consider product availability and product quality in each of the two scenarios.
Quantitative analysis V/S Qualitative analysis
The decision to make or buy involves both quantitative and qualitative analysis. You can calculate and compare quantitative considerations. Qualitative ones require subjective decisions and often need numerous opinions. Also, some of the factors involved can be quantified with certainty, while others must be estimated. The decision to make or buy requires a thorough analysis of all angles.
Quantitative factors to be considered may include items such as availability of production facilities, production capacity and necessary resources. They can also include fixed and variable costs that can be determined with certainty or estimated. Likewise, quantitative costs include the price of the product under consideration, as it is being priced by suppliers who offer the product on the market for sale.
Qualitative factors to be considered require more subjective judgment. Examples of qualitative factors include the reputation and reliability of suppliers, the long-term prospects for producing or purchasing the product and the possibility of changing or altering the decision in the future and the likelihood of altering or reversing the decision at a future date.
When a production company gets any order in bulk so to maximize the profit it makes a promise to deliver the products in a very short period. to meet the expectation, the firm outsources and gives orders to the small production companies which produce the same types of products. Due to the big competition and for survival these small firms accept and deliver the orders at a cheap rate and on time because the amount ordered is small. Here the small firms generally have no after-effects but the main producing firm has to undergo many types of risks and difficulties. Like the quality of products sometimes degrades and the customer doesn't get the exact product it ordered. This affects the reputation and goodwill of the firm. So here is how the application works. No doubt it is useful in many ways but also is very risky when it comes to the reputation of the firm.
Intellectual property can be owned by individuals or companies. Although many companies and individuals maintain their creations, many companies have this intellectual property with the general idea of selling it legally. And there are times when an individual may prefer to sell the intellectual property rather than retain it for themselves.
There are many different types of intellectual property, such as recordings, record labels, works of art, films, software programs, chips, software programs, discoveries and inventions. So it is easy to see that there are different areas of intellectual property available. When would it be beneficial for someone to sell their intellectual property? Not everyone has the means to implement their creation and may have to turn to someone else to implement it. For example, someone may have invented a unique tool, however, they do not have the means or money to start production or make money on a large scale. That person can see his invention materialize by finding a company that is willing to buy the idea and take it to the market for him. They can pay a full amount for the idea and obtain the legal rights to the invention by filing a patent on it in the name of the company.
Relevant and Irrelevant Cost
When deciding to make or buy, it is necessary to distinguish between relevant and irrelevant costs. Relevant costs to manufacture the product are all costs that could have been avoided if the product was not produced, as well as the opportunity cost incurred by using the production facilities to manufacture the product, as opposed to the next best alternative use of the production facilities. The relevant costs for purchasing the product are all costs associated with purchasing from the supplier. Irrelevant costs are those that will be incurred, regardless of whether the product is manufactured internally or purchased externally.
Earning Profit is the main objective of any firm. so there are many ways which help the company to make and increase their profit. one of these methods is again outsourcing. if the production company produces a product @ Rs. 10 per unit with Rs. 2 fixed cost and Rs. 8 variable costs. Now the game begins. A company gets an offer from a small company where it says that it will produce the product with @ Rs. 9. now if a company accepts the offer it is losing a rupee on every product produced because the company still has a fixed cost of Rs. 2. which in total makes the cost of product Rs. 11. so the company will not accept the offer. but if the same company says that it will produce the product @ Rs. 7 then the company will accept the offer because the company will in the end make an extra profit of a rupee( Rs. 7 costs to the producing company and Rs. 2 fixed costs of the firm itself).
So now the time comes for the company to choose the best way of production. if the company chooses to hire and give the other company the chance to produce it loses the opportunity cost on itself and if it produces all of the product itself then it loses the opportunity cost on the other source and also the profit.
A relevant cost is any cost that will differ between several alternatives. There is rarely a “one size fits all” situation for relevant or irrelevant costs. That is why they are often called differential costs. They differ between different alternatives.
The relevant costs are affected by a managerial choice in a given business situation. In other words, these are the costs that must be incurred in one managerial alternative and avoided in another.
Examples of relevant costs include:
Future cash flows cash expenses that will be incurred in the future,
Avoidable costs: only those costs that can be avoided in a given decision,
Opportunity costs: cash inflows that would have to be sacrificed,
Incremental costs: only incremental or differential costs related to the different alternatives.
The decision of the company whether to make the product in house or to outsource it to some other company depends upon a combination of all these factors. The company should not only focus on the costing part for this decision but also the qualitative part in order to make the correct decision for the company. I hope this blog helps you to understand why the company takes to outsource a particular product or why they dont.
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