Compare the costs that change, then test the capacity alternative
A make-or-buy decision should compare future costs and benefits that differ between the options. An absorbed full unit cost can mislead when fixed overhead continues after outsourcing. Conversely, making a component with apparently cheap variable cost can be uneconomic if it prevents a more valuable use of a scarce machine. The relevant-cost working needs both avoidable cash outflows and a supported opportunity-cost analysis.
Checked on 24 October 2026, this guide develops an internal management decision file using ICAI material identifying make-or-buy as an application of marginal costing, the Institute of Cost Accountants of India’s decision-making workbook and FAO’s management-accounting treatment of relevant and opportunity costs. The examples are original fictional cases, not statutory costing, tax-deductibility or outsourcing-law conclusions.
Fix the decision horizon and the actual alternatives
Define the component, acceptable specification, demand quantity, delivery period and production capacity. A one-quarter order and a five-year sourcing strategy can have different relevant costs. Wages or rent that cannot change during the quarter may become avoidable later; conversely, future supplier commitments may create new fixed obligations.
Specify what buying actually replaces. Does it eliminate conversion work, free a constrained resource, permit equipment disposal or merely shift costs between departments? Include costs of both transition and ongoing operation where they differ. A purchase quote without matching quality, timing and delivered quantities is not a complete alternative.
| Cost or benefit | Decision treatment | Evidence |
|---|---|---|
| Materials and conversion | Include the incremental cost or best alternative use | Bills of material, labour terms and cash-cost behaviour |
| Unavoidable fixed cost | Exclude the identical amount from the difference | Contracts and realistic action evidence |
| Avoidable fixed cost | Include what changes in the chosen horizon | Notice periods, termination and redeployment plans |
| Existing stock or machinery | Ignore sunk book cost, assess relevant disposal or use value | Resale, replacement and alternative-use support |
| Supplier option | Use landed incremental cost, not quote alone | Freight, inspection, nonrecoverable costs and transition |
| Released capacity | Include the best feasible incremental benefit once | Demand, bottleneck hours and contribution evidence |
An allocation is not proof of a saving
A component may carry a share of factory rent, depreciation and head-office overhead in the product-cost report. Outsourcing does not automatically remove those costs. Ask which payment or benefit actually changes and when. Exclude an identical unavoidable amount from the option difference, while retaining it in the wider profit and cash forecast where it still belongs.
Do not assume every variable-looking item is avoidable either. Labour can be contractually committed for the decision horizon, and materials may have already been purchased. The classification depends on the facts and alternatives, not just the expense account name. Preserve the manager’s proposed action that makes a claimed fixed-cost saving achievable.
Stock is not automatically free because its purchase is sunk
The historical purchase cost of existing inventory is sunk, but using it can sacrifice resale proceeds or another economic use. Where it must be replaced to meet other demand, replacement economics can matter. Where it has no alternative use and no resale value, its relevant value may differ. Document the actual best alternative rather than applying one blanket rule to all old stock.
The same distinction applies to equipment: book value or depreciation is not itself an incremental cash payment, while a genuine disposal receipt or new equipment payment may change the decision. Keep tax and financial-reporting effects in separately supported workings if material; this short-run illustration does not calculate them by assumption.
Count the best feasible capacity benefit once
If buying frees a bottleneck for profitable alternative output, measure the incremental contribution actually achievable from that use, subject to demand, hours and other resources. It can be shown as an opportunity cost of making or as a benefit of buying. Use one consistent presentation; adding it on both sides exaggerates the case for outsourcing.
A theoretical contribution is not enough if there is no buyer or the released hours occur when the alternative cannot run. Where several components compete for a bottleneck, compare the saving from making rather than buying per constrained hour. Ranking only the saving per unit can allocate scarce capacity poorly.
Use landed supplier cost and test the switching quantity
Include incremental freight, inspection, tooling, transition, nonrecoverable levies or other costs that the purchasing option actually causes. Exclude recoverable amounts from economic cost only where recovery is established, and separately consider cash timing. Do not insert a hypothetical GST credit merely to make a quote cheaper.
Where one option has an avoidable fixed cost and the options have different variable cost per unit, calculate their switching quantity for the defined horizon. Recheck the assumed cost behaviour around that point. The calculation does not guarantee supply availability or quality, and it is not a long-run strategic verdict where future rates and investment needs change.
Turn a numerical preference into a deliverable decision
Management should see the relevant-cost difference, assumptions, capacity plan, supplier risks and actions required to realise the benefit. Consider defects, delivery reliability, intellectual property, customer approvals and dependence, using evidence rather than invented financial penalties. A cheaper numerical option should not be approved if it cannot meet the required output.
After implementation, compare expected and realised volumes, avoided costs, supplier costs and freed-capacity benefits. Keep the original decision file so a later reviewer can distinguish a wrong assumption from poor execution. An accounting reduction in allocated unit cost is not a cash saving unless the underlying outflow or benefit changes.
Worked illustrations
These illustrations use fictional facts and expressly stated assumptions. Amounts are Indian rupees unless a different currency or unit is specified. They are independent examples, not findings about any actual client.
Illustrative example 1: Idle capacity and unavoidable allocation
Assume 1,000 components have incremental make cost ₹60 each and an unavoidable allocated fixed charge ₹40 each. A matching supplier quote is ₹75 per unit with no other differing cost and no alternative capacity use. Relevant make cost is ₹60,000 versus buy ₹75,000, so making saves ₹15,000. Comparing ₹100 full cost with ₹75 would incorrectly suggest outsourcing removes the unavoidable allocation.
Illustrative example 2: A real fixed-cost saving changes the choice
For 1,000 units, assume incremental make cost ₹60,000 plus a genuinely avoidable ₹20,000 supervision contract for this horizon. Relevant make cost is ₹80,000; buy cost is ₹75,000. Buying saves ₹5,000 if the contract saving is actually achievable. A reallocated supervisor salary that still must be paid would not meet that premise.
Illustrative example 3: A feasible alternative use has value
Assume make cash cost ₹60,000, buy cost ₹75,000 and released capacity could genuinely earn ₹25,000 additional contribution after its incremental costs. Making carries an opportunity cost ₹25,000, total economic cost ₹85,000. Buying therefore benefits the business by ₹10,000. Alternatively subtract ₹25,000 from buy cost, but do not count the benefit both ways.
Illustrative example 4: Existing materials have a resale opportunity
Assume materials already bought historically for ₹50,000 are no longer needed elsewhere but can be sold now for ₹20,000. Making the order uses them and requires further conversion cash ₹30,000; buying equivalent output costs ₹55,000. Relevant make cost is ₹20,000 forgone sale plus ₹30,000 conversion = ₹50,000, so making saves ₹5,000. The sunk ₹50,000 is not added again, and the material is not free.
Illustrative example 5: A quote is not the whole buying cost
Assume 1,000 units quoted at ₹70, plus incremental freight ₹3,000, inspection ₹2,000 and an expressly assumed nonrecoverable charge ₹5,000. Total buy cost is ₹80,000. If relevant make cost is ₹75,000, making saves ₹5,000. The charge is a fictional input, not a statement of any tax rate or credit restriction.
Illustrative example 6: Find the switching quantity
Assume making costs ₹50 per unit plus avoidable fixed cost ₹30,000 for the period; buying costs ₹65 per unit. Equality occurs at 30,000/(65 − 50) = 2,000 units. At 1,000 units, make ₹80,000 exceeds buy ₹65,000 by ₹15,000. At 3,000 units, make ₹1,80,000 is below buy ₹1,95,000 by ₹15,000, under the same valid cost assumptions.
Illustrative example 7: Rank savings per scarce hour
Assume making A instead of buying saves ₹10 per unit and uses two scarce hours; B saves ₹12 and uses four hours. Savings per hour are ₹5 for A and ₹3 for B. With 100 hours, demand limits A to 30 units and B to 20, and no other constraints: make A30 using 60 hours and B10 using 40 hours, saving ₹420. Making B20 first uses 80 hours, leaving A10 and saving only ₹340. The correct stated ranking improves the saving by ₹80.
Ten-step verification table
| Step | Verification | Evidence to retain |
|---|---|---|
| 1 | Define the decision and horizon | Specification, quantity, dates and matching alternatives |
| 2 | Map incremental make costs | Materials, conversion and actual cost behaviour |
| 3 | Test fixed-cost avoidability | Contracts, notice periods and achievable actions |
| 4 | Value existing resources by alternatives | Resale, replacement or best other-use evidence |
| 5 | Complete the landed buy cost | Quote, freight, inspection and nonrecoverable/transition items |
| 6 | Validate the capacity opportunity | Bottleneck hours, real demand and incremental contribution |
| 7 | Recalculate the option difference | No sunk costs, duplicate benefits or unsupported recoveries |
| 8 | Test quantity and constraint sensitivity | Switching quantity and saving per scarce resource |
| 9 | Review feasibility and wider obligations | Quality, supplier, operational and separate legal/tax review |
| 10 | Track realised outcomes | Actual savings, avoided payments and delivered capacity benefits |
Sixteen practitioner FAQs
1. Should supplier price be compared with absorbed full cost?
Not automatically. Identify costs and benefits that actually differ between the alternatives over the chosen horizon.
2. Is an allocated fixed charge automatically avoidable?
No. Establish the payment or economic benefit that changes and the action needed to achieve it.
3. Are all variable costs relevant?
Check the actual decision. Existing commitments and alternative uses can change the relevant amount.
4. Are old materials always free for the decision?
No. Using them can sacrifice resale proceeds, replacement capacity or another valuable use.
5. Is historical purchase cost itself relevant?
It is sunk, but the resource’s present alternatives may still create a relevant value.
6. Does depreciation equal a cash saving from outsourcing?
Not by itself. Review actual disposal, investment, tax and other differing effects separately.
7. What is opportunity cost here?
The benefit from the best feasible alternative that making prevents, such as incremental contribution from released capacity.
8. Can the capacity benefit be counted on both options?
Do not double count. Show it once as a make opportunity cost or a buy benefit in a consistent bridge.
9. Is theoretical alternative production enough?
No. Verify demand, timing, bottleneck hours and other resources needed to realise the contribution.
10. Why can per-unit savings give the wrong ranking?
Components may use different amounts of the scarce resource. Compare savings per constrained hour under the actual limits.
11. What belongs in the buying alternative?
The matching delivered output and all differing incremental supplier, logistics, inspection, transition and other relevant costs.
12. Can recoverable tax be assumed away?
Establish actual recovery and treat cash timing separately. Do not invent a credit to improve the result.
13. Is the switching quantity valid for every volume?
Only while the stated fixed and variable cost assumptions remain valid. Test capacity and contract changes.
14. Does a short-run make preference settle long-run sourcing?
No. Longer horizons can change avoidable costs, investment needs, supplier terms and strategic risks.
15. Can the cheapest calculation override quality requirements?
No. The alternative must meet the required specification and feasible delivery conditions.
16. How should management verify the decision afterwards?
Compare actual quantities, avoided costs, landed supplier costs and realised capacity benefits against the original supported assumptions.
Conclusion
Choose on the supported incremental difference, then confirm feasibility and the actions required to realise it. Track actual savings and capacity benefits separately from changes in allocated accounting cost.