Make-or-Buy
Make-or-buy is the business decision of whether a company produces a service, component or product itself (make / in-house production) or purchases it externally (buy / external sourcing). The basis is a cost comparison plus strategic, qualitative and risk criteria.
Make-or-buy (in-house production versus external sourcing) is the business decision of whether a company delivers a component, an assembly, a finished product or a service itself or obtains it from an external supplier. "Make" stands for in-house production with the company’s own resources, "buy" for purchasing on the market. The question arises both for individual items on a bill of materials and strategically for entire functions such as IT, logistics or accounting.
At its core, make-or-buy is a comparison: the costs and benefits of in-house production are weighed against the costs and benefits of external sourcing. A pure cost comparison is rarely enough on its own – the decision also factors in capacity utilization, quality, delivery reliability, protection of know-how, dependence on the supplier and the strategic importance of the service. Make-or-buy is therefore both a short-term, cost-driven planning decision and a long-term, strategic decision of principle.
At a glance
- Make = in-house production with your own resources, buy = external sourcing on the market
- Basis: a cost comparison plus strategic, qualitative and risk criteria
- Short term, variable costs count; long term, fixed and investment costs matter too
- Affects individual parts as much as entire functions (IT, logistics, accounting)
- The ERP provides the data basis: costing, capacity, purchasing conditions
What make-or-buy decides at its core
A make-or-buy decision is about determining the cheapest and at the same time strategically most sensible source of supply for a service. Classically this concerns manufactured parts: should a housing, a circuit board or a screw be produced in the company’s own plant or bought from a supplier? But the concept reaches far beyond production. Outsourcing accounting, IT operations, warehouse logistics (fulfillment) or customer service is also a make-or-buy question – here usually under the heading of outsourcing.
A distinction is made between the short-term and the long-term perspective. In the short term, with capacities and equipment already in place, it is mainly the variable costs of in-house production that must be compared with the purchase price of external sourcing; the fixed costs are incurred anyway. In the long term, by contrast, all costs count – including depreciation and investments in machinery and staff. A decision that favors "make" in the short term can favor "buy" in the long term, and vice versa.
How a make-or-buy analysis works
The methodical core is a structured comparison in several steps. First, the costs of in-house production are determined: material, production and pro-rata overhead costs from the costing. Against these stand the full costs of external sourcing – not just the purchase price, but also procurement, transport, quality assurance and process costs. Only this comparison based on the relevant costs provides the business foundation.
Because a pure cost calculation ignores important aspects, it is supplemented with qualitative criteria. These include the strategic importance of the service (core competence or not), the protection of know-how and intellectual property, the achievable quality, security of supply and dependence on a single supplier (vendor lock-in). Both are often brought together in a utility or portfolio analysis that weighs costs and strategic factors against each other.
Cost comparison: relevant costs instead of full costs
A common mistake is to cost in-house production at full cost even though the fixed costs cannot be reduced in the short term. Only the costs that actually change as a result of the decision are decision-relevant. With free capacity, these are mainly the variable costs of in-house production; the pro-rata fixed costs would continue to run even with external sourcing. Only when external sourcing actually allows capacity, staff or equipment to be reduced do these costs become decision-relevant. The break-even quantity shows from which volume in-house production pays off despite fixed costs.
Qualitative and strategic criteria
Beyond the numbers, soft factors often decide the outcome. Core competencies that differentiate the company in competition are rarely outsourced – even if the purchase were cheaper on paper – because otherwise know-how and control would be lost. Conversely, for standard parts without strategic value, much speaks for external sourcing, because the company can concentrate on its core business. Flexibility, access to innovation via the supplier and the risk of dependence also feed into the assessment.
Why make-or-buy is strategically important
Make-or-buy decisions determine a company’s depth of value creation – that is, the share of the service it delivers itself. A high depth of production ties up capital and fixed costs but promises control, quality and independence. A low depth of production makes the company more flexible and less capital-intensive, but increases dependence on suppliers and supply chains. Every decision shifts this balance and thus directly affects cost structure, risk and competitiveness.
Especially in volatile markets, the question is not a one-off but a recurring one. Rising purchase prices, supply bottlenecks or free in-house capacity can make a previously purchased part attractive for in-house production again (insourcing) – and vice versa. A systematic make-or-buy process ensures that such decisions are made transparently, on reliable data and not from the gut.
Make-or-buy in the ERP system
An ERP system provides the data basis for well-founded make-or-buy decisions because it brings costing, production and purchasing together in one data model. From the manufacturing bill of materials and the routing, in-house production can be costed – material costs, standard times and the cost rates of work centers add up to the manufacturing costs. On the buy side, the supplier master and the purchasing conditions hold the current purchase prices, quantity scales and replenishment lead times. Many systems flag each item in the item master via a procurement indicator as an in-house or purchased part, which MRP and material planning evaluate.
In day-to-day operations, this indicator controls material requirements: for a "make" part, material requirements planning generates a production order; for a "buy" part, a purchase requisition or purchase proposal. Analyses from reporting and business intelligence – such as capacity utilization, price trends or contribution margins – help to review the decision regularly. This turns make-or-buy from a one-off project decision into a data-driven, repeatable process.
Distinction: make-or-buy, outsourcing and sourcing strategy
Make-or-buy is the umbrella term for the fundamental question of "make it yourself or buy it". Outsourcing refers to the specific case in which a service previously delivered internally is permanently handed over to an external provider – that is, a "buy" decision for an entire process. The sourcing strategy goes further and defines how purchasing is done: from how many suppliers (single vs. multiple sourcing), from which regions and with what kind of ties. Make-or-buy thus clarifies the whether, the sourcing strategy the how of external sourcing.
Example
Example: a mid-sized electronics manufacturer
A mid-sized manufacturer of measuring instruments has so far produced its control boards itself. At an annual volume of 8,000 units, variable costs of €42 per board are incurred, plus pro-rata fixed costs from the SMD assembly line. A specialized contract manufacturer offers the same board for €46 including testing. Based purely on unit price, in-house production looks cheaper.
The make-or-buy analysis in the ERP, however, paints a different picture: the assembly line runs at 95 percent utilization, and every in-house board blocks capacity for higher-value assemblies. Once the opportunity costs and the tying up of staff are factored in, external sourcing becomes attractive – especially as the contract manufacturer delivers shorter replenishment lead times and tested quality. The company switches the board to "purchased" in the item master; material requirements planning now generates purchase proposals instead of production orders. The freed-up capacity is used for higher-margin in-house products.
Frequently asked questions
Matching ERP systems
Related services
Questions about Make-or-Buy in your ERP project?
We advise vendor-neutrally – and implement it ourselves on request.