Differential Analysis: Make or Buy

There are numerous ways to organize a differential analysis make or buy analysis, but here we will focus solely on the incremental revenues and costs that occur from choosing one scenario over the other.

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In a “make or buy” scenario, our focus will almost always be solely on the costs involved with the decision. A decision to make vs. buy will usually not result in any differences in revenues for a company, so when evaluating these two alternatives, focus on the differences in costs.

Many of make or buy scenarios will present both variable costs and fixed costs. It is very important that you have a strong understanding of the differences between variable costs and fixed costs. If you feel that you need a refresher on the differences between variable costs and fixed costs, click HERE [TO BE UPDATED].

When evaluating the variable costs of the two scenarios, the costs should be fairly straight forward. If we choose to buy something, our variable costs will likely be the cost of purchasing that item and perhaps some shipping or other costs involved in the purchased. If we instead choose to make an item, our variable costs will likely include direct materials, direct labor, and variable factory overhead.

Fixed expenses will likely not affect our decision to make or buy–unless the problem says that there are avoidable fixed expenses. For example, let’s pretend that we make gift boxes for anniversaries and birthdays. Let’s also pretend that these gift boxes include a mug with a graphic, which I currently add to the mug myself. If I decide to instead begin buying the mugs with the graphic already included, my differential analysis will likely also include consideration of that equipment that I have been using to apply the graphic to the mug since I will no longer need it. This would be an example of an avoidable fixed costs. If instead I am going to keep the equipment whether I make or buy because I use it for other areas of my business, then the equipment would be an unavoidable fixed cost, and I technically could ignore it in my evaluation if I would like to since it is an unavoidable fixed cost that would still be in my business under either scenario–make or buy.

These scenarios can be hard to conceptualize without visuals, so please try taking a moment to watch through the video below.

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It looks like you’ve mastered this lesson. Good work!