Make or buy explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
Short-term choices come up weekly: should we make this part or buy it, which product deserves the scarce machine hours, can we take an order below our usual price, is a loss-making line worth keeping? Each can be settled by asking one question: what will change in cash and in contribution if we do it?
Relevant costs are future costs that differ between the alternatives; sunk costs and unavoidable fixed costs are irrelevant. Where one resource limits output, rank products by contribution per unit of that resource, not by contribution per unit. A special order is worth taking if its price exceeds the extra cost it causes (plus the contribution given up elsewhere). A line should be shut only if its contribution is less than the fixed costs that would disappear. Use it for decisions measured in months, not for setting long-run prices.
The framework and the data needed
You need, for each product, price, variable cost and use of the scarce resource; the fixed costs and which of them are avoidable; the spare capacity, if any; and supplier quotes. Relevant cost = the future cash cost that changes, plus the opportunity cost of any resource that has another use. Apportioned overhead that continues regardless is irrelevant. The contribution notions are the same as in break-even analysis. These choices are part of a cost reduction and profitability review.
The four decisions
| Decision | Compare | Rule |
|---|---|---|
| Make or buy | Avoidable cost of making against purchase price (plus opportunity cost of released capacity) | Buy only if the purchase price is lower than the relevant cost of making |
| Key factor | Contribution per unit of the limiting resource | Fill the scarce resource with the highest-ranking products first |
| Special order | Extra revenue against extra variable cost (plus any displaced contribution) | Accept if the gain is positive and regular prices are not damaged |
| Shut-down | Contribution of the line against avoidable fixed costs | Close only if avoidable fixed cost exceeds contribution |
Worked example: a fabrication unit
The unit makes three products; machine time is the limit. All figures assumed.
| A | B | C | |
|---|---|---|---|
| Selling price (₹) | 900 | 1,200 | 600 |
| Variable cost (₹) | 600 | 780 | 420 |
| Contribution per unit (₹) | 300 | 420 | 180 |
| Machine hours per unit | 3 | 5 | 2 |
| Contribution per machine hour (₹) | 100 | 84 | 90 |
| Maximum demand (units) | 400 | 300 | 500 |
Machine hours available: 3,000. Fixed costs: ₹150,000.
Key factor. Ranked by contribution per machine hour: A (100), C (90), B (84). Fill the hours in that order.
- A: 400 units × 3 = 1,200 hours.
- C: 500 units × 2 = 1,000 hours (cumulative 2,200).
- B: the remaining 800 hours ÷ 5 = 160 units.
| Product | Units | Hours | Contribution (₹) |
|---|---|---|---|
| A | 400 | 1,200 | 120,000 |
| C | 500 | 1,000 | 90,000 |
| B | 160 | 800 | 67,200 |
| Total | 3,000 | 277,200 |
Profit = 277,200 − 150,000 = ₹127,200.
If instead the unit ranked by contribution per unit (B first, since 420 is highest): B 300 units = 1,500 hours; A 400 units = 1,200 hours (cumulative 2,700); C with 300 hours = 150 units. Contribution = 300 × 420 + 400 × 300 + 150 × 180 = 126,000 + 120,000 + 27,000 = 273,000, lower by ₹4,200 (277,200 − 273,000).
Make or buy. The unit makes 2,000 components a year: variable cost ₹140 each (material 70, labour 40, variable overhead 30). A supplier offers them at ₹160. Making costs 2,000 × 140 = 280,000; buying costs 320,000. If the capacity used would otherwise be idle, making saves ₹40,000 and the unit should make. But the component takes 0.3 machine hours each, 600 hours in all, on the same machines (hours that sit outside the 3,000 above while the unit makes the component). Buying would release those 600 hours, which could make 120 more units of product B (600 ÷ 5), a use for 600 of the 700 hours that product B's unmet demand needs (140 units × 5 hours). Those hours earn 84 each: 600 × 84 = 50,400. Buying costs 40,000 extra and earns 50,400, a net gain of ₹10,400. With scarce machine time, buy; with idle time, make. Qualitative factors matter too: supplier reliability, quality control and the risk of creating a competitor.
Special order. In a slack month, a customer asks for 150 units of C at ₹500. Variable cost is 420, so contribution is 80 a unit, 150 × 80 = ₹12,000. If the machine hours are idle and regular customers will not hear of the price, accept. If the hours are scarce, the order uses 150 × 2 = 300 hours that product B could use at 84 an hour, 25,200; the displaced contribution (25,200) exceeds 12,000, so reject. In each case fixed cost does not enter.
Shut-down. Suppose product B's line had avoidable fixed costs (a dedicated operator and tooling) of ₹20,000. B's contribution in the plan is 67,200, far above 20,000, so keep it. A line closes only when its contribution is below the fixed costs saved, or when the released capacity earns more elsewhere.
What the owner decides. Schedule machine time in the order A, C, B; buy the component while machine hours are scarce; take extra work at low prices only when machines would otherwise be idle.
How to read the results
The rules hold for the short term, when fixed costs are given. In the long run, every cost must be covered, so a line that survives on contribution today needs a plan to earn its share of fixed costs. Where the lower-priced decision sets a precedent, count the price damage with the regular customers. Cost behaviour in this analysis follows the cost classification. The same idea of incremental analysis applies in joint product decisions and in lease or buy.
Common mistakes
- Including apportioned fixed overhead as a cost of making.
- Ranking products by contribution per unit when a resource is scarce.
- Taking a special order that quietly uses the scarce hours of better products.
- Shutting a line that covers its avoidable costs.
- Forgetting the unit's long-run need to recover all costs.
Need help with short-term decisions?
If your make-or-buy and pricing choices are made on full cost, we can help set up a relevant-cost analysis for them through a cost reduction and profitability review.
Key takeaways
- Relevant costs are future, avoidable and different between alternatives.
- With one scarce resource, rank by contribution per unit of that resource.
- Make or buy: compare the avoidable cost of making plus any opportunity cost with the purchase price.
- Special orders: accept if extra revenue exceeds extra cost and displaced contribution.
- Shut a line only when contribution is below the avoidable fixed cost.
Read next
- Break-even point, contribution and margin of safety
- Joint products and by-products
- Lease or buy decision
Disclaimer: The methods described are standard cost accounting and financial management techniques. The worked example uses an invented business and invented figures, including any tax, interest or exchange rate, which are assumptions for illustration and not current rates. Where the article refers to a legal requirement, the linked guide and the official text should be checked. This article is general information, not legal advice; check the official text before acting.