Make or buy: Cost analysis as a decision-making aid for in-house production vs. external procurement

The decision between in-house production and external procurement is a fundamental strategic decision for companies of all sizes. This so-called make-or-buy decision not only influences short-term costs, but also has a long-term impact on competitiveness and corporate structure.

Cost and risk analysis is at the heart of the decision-making process. It provides the quantitative basis for objectively assessing the financial impact of both options. Without a well-founded cost analysis, the make-or-buy decision is often characterised by subjective assessments or gut feeling. This can lead to costly mistakes that burden the company for years to come.

This blog article offers decision-makers and experts a practical guide to carrying out a structured cost analysis. We highlight both methodological principles and specific application examples. The aim is to provide you with the necessary tools to make make-or-buy decisions based on solid data. We take into account not only the obvious cost factors, but also hidden costs and qualitative aspects that are essential for a thorough analysis. The methods presented here can be applied to various industries and company sizes.

The make-or-buy decision is one of the classic strategic activities in day-to-day business. In order to carry out a well-founded analysis, a clear understanding of the two options is first required.

In-house production, the ‘make’ approach, refers to the manufacture of products or the provision of services by the company itself. This includes the use of the company's own employees, its own facilities and the utilisation of internal expertise. In-house production generally ensures a high level of control over quality, processes and confidentiality. However, it requires corresponding investments in personnel, machinery, training and infrastructure. Companies that rely on in-house production can strengthen their core competences and benefit from the expertise they have built up over the long term.

In contrast, external procurement, the ‘buy’ approach, refers to the procurement of products or services from external providers. This strategy allows companies to concentrate on their core competences while specialised suppliers take on other tasks. External procurement often offers cost benefits through economies of scale for suppliers and reduces the amount of capital tied up within the company. It can also open up access to specialised knowledge and technologies that are not available internally.

In practice, the make-or-buy decision can be found in numerous areas of application. Car manufacturers are regularly faced with the question of which components they should produce themselves and which they should buy in. IT departments decide between developing their own software and purchasing standard solutions. Production companies consider whether maintenance work should be carried out by their own staff or by external service providers.

The complexity of these decisions is further increased by current developments such as globalised supply chains, faster product life cycles and increasing specialisation. There is no one-size-fits-all answer as to whether ‘make’ or ‘buy’ is the better option. Instead, each decision must be made individually, taking into account the specific company and market situation. The cost analysis is a central, but not the only decision criterion. It creates the basis for a structured decision-making process, which will be analysed in more detail later in this article.

The cost analysis forms the foundation for a fact-based make-or-buy decision. Essentially, it involves a systematic analysis of all relevant costs associated with in-house production or external procurement. Such an analysis goes far beyond a simple comparison of purchase prices and direct production costs.

A comprehensive cost analysis covers all cost factors over the entire life cycle of a product or service. This includes development costs, ongoing operating costs, maintenance costs and, finally, disposal costs. Only by taking this holistic approach can companies identify hidden cost drivers and create a realistic basis for comparison.

The cost analysis fulfils several central functions in the decision-making process. Firstly, it creates transparency about the actual financial impact of both options. It helps to supplement purely subjective decision-making factors with reliable figures. It also serves as a communication tool between different departments and hierarchical levels, as it establishes a common factual basis. Last but not least, the cost analysis also makes it possible to monitor success retrospectively by comparing the actual costs incurred with the forecast values.

The cost analysis differs from other analysis tools due to its specific focus on monetary aspects. While a SWOT analysis, for example, considers qualitative factors such as strengths and weaknesses, or a risk analysis assesses potential threats, the cost analysis concentrates on the financial dimension. It complements these other tools and should ideally not be considered in isolation, but as part of a more comprehensive decision-making process.

Despite its central importance, cost analysis faces challenges in practice. Recording all relevant costs often requires detailed data that is not always available. In addition, assumptions must be made about future developments, which is naturally associated with uncertainties. Another problem is translating qualitative factors such as quality differences or strategic advantages into monetary values.

Modern cost analysis has developed from a pure calculation instrument into a strategic tool. It also increasingly takes into account long-term and indirect effects such as flexibility advantages, learning curve effects or reputational risks. This broader perspective helps make make-or-buy decisions not only on the basis of short-term cost optimisation, but also in terms of long-term corporate success.

A well-founded make-or-buy decision requires an in-depth understanding of the various types of costs that need to be taken into account when analysing. The correct recording and allocation of these costs forms the basis for a meaningful comparison between in-house production and external procurement.

The distinction between fixed costs and variable costs plays a central role in cost analysis. Fixed costs remain constant regardless of the production volume and are incurred even when production stops. These include, for example, building rents, basic salaries for permanent staff or depreciation on machinery. Variable costs, on the other hand, change directly with the production volume. Typical examples are material costs, energy consumption in production or performance-related remuneration. When making the make-or-buy decision, it is particularly important to note that in-house production often incurs high fixed costs, while variable costs tend to dominate in the case of external procurement. This difference can have a considerable impact on profitability if capacity utilisation fluctuates.

Another important differentiation is between direct costs and overheads. Direct costs can be directly allocated to a specific product or order, such as specific raw materials or product-related labour hours. Overheads, on the other hand, are incurred for several products or the entire company and must be distributed using allocation keys. These include administrative costs or IT infrastructure costs, for example. One challenge of the make-or-buy analysis is that an appropriate share of overheads must be taken into account for in-house production, whereas external procurement often involves a complete price that already includes the supplier's overheads.

The distinction between direct and indirect costs partially overlaps with the aforementioned categories, but follows a different logic. Direct costs are directly related to the provision of services, while indirect costs are only indirectly related. In the make-or-buy decision, direct costs are often overestimated, while indirect costs for quality assurance, warehousing or coordination, for example, are underestimated.

Special attention should be paid to opportunity costs and hidden costs, which are often not recognised in traditional cost accounting systems. Opportunity costs refer to lost revenues or benefits due to the utilisation of resources for a specific purpose rather than for other possible uses. For example, if production space is used for in-house production, it is not available for other, potentially more profitable activities. Hidden costs include factors that are difficult to quantify, such as complexity costs due to additional products, coordination costs with suppliers or costs due to quality fluctuations. These costs are often underestimated or completely ignored in practice, but can have a significant impact on profitability.

Ideally, these different types of costs should be taken into account in a structured process. The costs should not be considered in isolation, but analysed in their entirety and interaction. This is the only way to draw a realistic picture of the economic consequences of a make-or-buy decision.

A methodical and structured approach is crucial for a meaningful make-or-buy cost analysis. The following process provides a practical guide on how companies can carry out this analysis systematically.

The first step consists of careful data collection and preparation. This involves collating all relevant cost information from various sources. This includes data from financial accounting, controlling, production and offers from potential suppliers. The quality of this data largely determines the reliability of the entire analysis. The information should therefore be checked for completeness, up-to-dateness and consistency. It is also advisable to prepare the data in a standardised format to facilitate subsequent comparisons. In the case of incomplete data, well-founded estimates or empirical values from comparable projects can be used.

In the second step, the costs for in-house production are determined. These include direct material costs, personnel costs for production and quality assurance as well as pro rata machine costs including depreciation. Added to this are space costs, energy costs and any necessary investments in special tools or equipment. The costs for product development, process planning and start-up phases must also be taken into account. It is particularly important to realistically estimate the overheads that need to be allocated to the product. Here, only the actually relevant cost shares should be included that are incurred additionally in the case of in-house production or that could actually be saved in the case of external procurement.

The third step is dedicated to determining the costs for external procurement. The most obvious factor is the purchase price, which can, however, be influenced by discount and quantity agreements. Transport costs, customs duties and insurance as well as any currency fluctuations must also be taken into account. Other important factors are the costs for quality checks of incoming goods, warehousing costs and the administrative effort for ordering processes and supplier management. Potential costs due to delivery risks, such as production losses due to late deliveries, should also be taken into account. The costs of contract negotiations, legal reviews and any necessary adjustments to the purchased product should also not be neglected.

The fourth step involves the actual cost comparison, often supplemented by a break-even analysis. Here, the calculated costs for in-house production and external procurement are systematically compared. It is important to relate the costs to a common basis, for example per unit, per month or over the entire product life cycle. The break-even analysis determines the production quantity at which in-house production pays off compared to purchasing. This is particularly relevant if fluctuating or uncertain sales figures are to be expected. Graphical representations can help to visualise the comparison and clearly identify decision points.

The fifth step comprises scenario analyses and sensitivity analyses in order to take uncertainties and risks into account. Various assumptions are analysed here, for example regarding production volumes, material prices or personnel costs. Sensitivity analyses show how strongly the result depends on certain parameters. If even small changes to a parameter would lead to a different decision, this indicates an increased risk. In this case, additional information should be obtained or risk buffers factored in. The robustness of the decision can be checked by analysing different scenarios - for example, a best-case, most-likely and worst-case scenario.

When carrying out these steps, transparency regarding assumptions and calculation methods is crucial. All parties involved should be able to understand the basis of the analysis. In addition, the cost analysis should be understood as a dynamic process that should be repeated if the framework conditions change or new findings emerge. A carefully conducted cost analysis not only provides a decision-making basis for the current make-or-buy question, but also creates valuable knowledge about cost drivers and structures in the company that can be used for future strategic decisions.

Although cost analysis is the centrepiece of the make-or-buy decision, a purely monetary approach often falls short. Numerous other factors can significantly influence the long-term success of a company and should therefore be included in the decision-making process.

Quality and expertise are critical factors that have an impact beyond the immediate cost advantage. With in-house production, the company retains full control over quality standards and can influence them directly. In addition, in-house knowledge is built up and deepened, which can lead to innovations and competitive advantages in the long term. With external procurement, on the other hand, the company may benefit from the specialisation and expertise of the supplier. This can be particularly advantageous for complex components or processes that are not part of the core business. The decision should therefore also depend on whether strategically important expertise is involved and how well quality assurance can be guaranteed with external suppliers.

Flexibility and delivery times influence a company's ability to react to market changes. In-house production generally enables greater flexibility in the event of changes at short notice, whether in terms of product specifications, quantities or deadlines. Direct control of production allows faster adjustments without lengthy negotiations with suppliers. On the other hand, buying in can offer advantages when demand fluctuates, as capacity problems are externalised. In addition, external procurement often eliminates long lead times for building up in-house production capacities. The decision should therefore take into account how volatile the market is, how predictable demand is and how critical fast response times are for business success.

Dependence on suppliers and the associated risks are another important aspect. If a company is highly dependent on a few or even a single supplier, supply bottlenecks, price increases or quality problems can threaten its existence. The loss of confidential information or expertise to suppliers, who may also be working with competitors, also harbours risks. In-house production reduces these external dependencies. The market power of potential suppliers, the availability of alternative sources of supply and the importance of the product or component for the company's own business model should therefore be taken into account when making a decision.

Strategic considerations go beyond the operational horizon and look at long-term corporate goals. The question of whether a component or process is a core competency or could become one in the future is crucial. Components with high differentiation potential are often better produced internally in order to create and protect unique selling points. Considerations regarding vertical integration, positioning in the value chain or long-term technology development can also play a role. Social trends such as sustainability and regional production can also provide strategic arguments in favour of or against in-house production. When making a decision, it is therefore important to check that it is in line with the long-term corporate strategy and vision.

The weighting of these non-monetary factors depends heavily on the individual company situation. An established company with a strong market position will set different priorities than a start-up with limited resources. A sensible approach is to assess these qualitative factors in a structured manner and - where possible - to quantify them. For example, risks due to supplier dependency can be integrated into the cost analysis in the form of risk surcharges or flexibility advantages as option values. Ultimately, the make-or-buy decision should be based on a balanced consideration of both the cost aspects and these other decision factors in order to ensure the long-term success of the company.

Successfully carrying out a make-or-buy cost analysis requires more than just the application of accounting principles. Valuable tips can be derived from practical experience that lead to high-quality results and help to avoid typical pitfalls.

One of the most common mistakes in make-or-buy analyses is the incomplete recording of relevant costs. Indirect and hidden costs in particular are often overlooked. This applies, for example, to coordination costs in external procurement or complexity costs in in-house production. Another classic mistake is the overly optimistic assessment of a company's own capabilities and capacities. Many companies underestimate the costs of in-house production and overestimate possible synergy effects. To avoid these mistakes, it is advisable to critically scrutinise all assumptions and to incorporate empirical values from past projects. Consulting independent experts can also help to identify blind spots in the analysis. In addition, safety buffers for costs and schedules should always be taken into account, especially for new or complex products.

The use of suitable software and tools can significantly increase the quality and efficiency of cost analyses. Specialised solutions enable the integration of data from different areas of the company and offer powerful analysis functions. Specific simulation tools can also be used for more complex decisions, such as Monte Carlo simulations for risk analysis. Visualising the results using diagrams and dashboards also makes it easier to understand and communicate the results of the analysis. When selecting tools, attention should be paid to user-friendliness, adaptability to specific company needs and the ability to document assumptions and calculation steps.

The involvement of relevant experts and stakeholders is another success factor. A make-or-buy decision typically affects several areas of the company with different perspectives and interests. Representatives from purchasing, production, development, quality management and finance contribute valuable expertise and cover various aspects of the decision. Involving these stakeholders at an early stage not only improves the quality of the analysis, but also promotes the subsequent acceptance and implementation of the decision. The involvement of employees with experience from previous make-or-buy projects, who can provide practical advice on typical challenges, is particularly valuable. For strategically important decisions, top management should also be involved in order to ensure consistency with the corporate strategy.

An iterative approach has proven successful for the analysis process itself. Instead of a one-off comprehensive analysis, the main cost drivers should first be identified and roughly evaluated. Based on these initial results, a decision can then be made as to which areas require more detailed analysis. This step-by-step approach saves resources and concentrates the analysis capacities on the factors that are relevant for decision-making. At the same time, the analysis should be understood as a continuous process. Once the make-or-buy decision has been implemented, the actual costs and effects should be systematically recorded and compared with the forecasts. This post-calculation provides valuable insights for future decisions and helps to continuously improve the analysis methods.

Professional documentation completes the analysis process. All relevant assumptions, data sources, calculation methods and interim results should be clearly recorded. This not only makes the decision traceable at a later date, but also facilitates adjustments in the event of changed framework conditions. Good documentation also serves as a valuable knowledge resource for future make-or-buy decisions and contributes to organisational learning.

Professional costing software has become an indispensable tool for well-founded make-or-buy decisions. Modern software solutions offer far more than simple calculation functions. They integrate data from different areas of the company such as ERP systems, production planning and financial accounting, thus creating a standardised database for analysis. These systems also enable automatic updating in the event of changes to input factors such as material prices, labour costs or energy costs. This ensures that decisions are always based on up-to-date data and significantly reduces the amount of manual maintenance required.

A key advantage of specialised costing software is its ability to model complex scenarios and their effects. Companies can run through different production quantities, material usage, supplier options or investment variants and compare the results immediately. Advanced solutions also offer integrated functions for risk analysis, for example through Monte Carlo simulations that take into account uncertainties in the input parameters. This allows not only the expected costs, but also their fluctuation ranges and probabilities of occurrence to be estimated. This multi-dimensional approach enables a much more nuanced decision-making process than conventional calculation methods.

Particularly valuable are integrated dashboards and visualisation tools that make complex cost structures and comparison scenarios comprehensible even for non-financial experts. This promotes cross-departmental communication and makes it easier to present the results of analyses to decision-makers.

The make-or-buy decision is one of the fundamental strategic decisions in day-to-day business. The structured cost analysis presented in this article provides a reliable framework for putting this complex decision on a solid factual basis. As has been shown, a well-founded analysis goes far beyond a simple comparison of purchase prices with direct production costs. Rather, it takes into account the entire spectrum of relevant cost types, from fixed and variable costs to direct costs and overheads through to hidden and opportunity costs. Only by taking this holistic view can companies arrive at economically viable decisions.

However, practical experience clearly shows that pure cost considerations alone are not enough. Factors such as quality, flexibility, supplier dependency and strategic orientation play an equally important role in the long-term success of a company. A balanced make-or-buy decision must therefore take both quantitative and qualitative aspects into account. This requires an interdisciplinary approach in which experts from different areas of the company contribute their expertise. The methods and tools presented, in particular specialised costing software, support this process and help to manage the complexity.