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Make or buy, and outsourcing

Examples checked

In one minute

Deciding which activities to do yourself and which to pay a specialist for.

The big idea: Buy what a specialist does cheaper or better and that does not set you apart; keep what does. The quote from a supplier is never the whole cost: freight, managing the supplier and the overhead that stays behind all count.

Works when
When a specialist has real scale or skill you lack, the activity is not what customers choose you for, and the spec is easy to write down.
Fails when
When you outsource what makes you different, lose the skill to manage the supplier, or ignore the costs that stay behind.
Check this number first
Full in-house cost per unit, split into variable and fixed. Only the costs that disappear count as savings.
In the worked example
Gain from buying: minus USD 0.30 (USD millions a year). See it add up

What it is

Every company decides what to do in house and what to buy. Outsourcing means handing an activity to another company: manufacturing, IT, customer service, accounting. Offshoring means moving it to another country, whether in house or outsourced. Bringing work back in is called insourcing.

  • Outsource manufacturing. A contract manufacturer makes your product to your design.
  • Outsource services. IT, call centres, finance and HR work done by a service provider.
  • Insource. Bring back in house work you used to buy, often after quality or control problems.

Why companies do it

The economic logic, most important first. A move usually rests on one or two of these.

  • Scale. A specialist serving many clients spreads its fixed costs and learning over far more volume than you can.
  • Capital efficiency. You do not need to own the factories or data centres, so less capital is tied up.
  • Focus. Management time goes to what customers choose you for, such as design, brand or software.
  • Transaction costs. Buying works well when the job is easy to specify and check; when it is not, contracts get costly and making it yourself wins.

When it creates value, and when it destroys it

Creates value when

  • The supplier has scale or skill you cannot match, and several suppliers compete for the work.
  • The activity is standard and easy to specify and measure.
  • The freed capital and management time go to something that earns more.
  • You keep enough skill in house to manage the supplier and switch if needed.

Destroys value when

  • You outsource what sets you apart and suppliers sell the same capability to your rivals.
  • One supplier becomes the only one that can do the work, and raises prices.
  • Quality or delivery problems cost more than the savings.
  • The overhead you meant to cut stays, because it was shared with other activities.

The numbers to check

Ask for these, in this order, before you recommend the move.

  1. Full in-house cost per unit, split into variable and fixed. Only the costs that disappear count as savings.
  2. Supplier price plus freight, duties and management. The total cost of buying, not the quote.
  3. Overhead that stays after the activity leaves. Shared rent, systems and managers often remain.
  4. One-off cost of the switch. Severance, transfer and quality checks.
  5. Number of suppliers able to do the work. Fewer than two or three means the supplier will hold the power.

Worked example (illustrative)

Rounded numbers for a made-up business, shaped like real ones. Positive lines add to profit; negative lines are costs.

A machine maker builds 1 million components a year in house at USD 8.00 each: USD 4.00 materials, USD 2.50 labour, USD 1.50 overhead. A supplier quotes USD 7.00. 40 percent of the overhead would stay after the line closes.

Worked example for Make or buy, and outsourcing, in USD millions a year. Illustrative figures.
LineUSD millions a year
Price saving: (USD 8.00 minus USD 7.00) x 1 million componentsUSD 1
Freight from the supplierminus USD 0.40
Managing the supplier and checking qualityminus USD 0.30
Overhead that stays: USD 1.50 x 40 percent x 1 millionminus USD 0.60
Gain from buyingminus USD 0.30

Check: the lines above add up to the total.

The numbers that decide it

Apparent saving from the quote alone
12.5 percent
Supplier price at which buying breaks even
USD 6.70

So what: The quote looks 12.5 percent cheaper, but once freight, managing the supplier and the overhead that stays are counted, buying costs USD 0.3 million more a year. Buying wins only below about USD 6.70 a component, or if the freed space and staff can be used for something else.

Real examples

Companies that made this move, by region, with what happened and a source checked on the date shown.

How to recommend it in a case

Answer first, then the reasons with numbers, then the risk and the next step. Three sentences, said out loud.

I recommend we keep making the component for now, because the supplier's quote of USD 7.00 looks 12.5 percent cheaper but costs us about USD 0.3 million more a year once everything is counted.

Freight and supplier management add USD 0.70 a unit, and USD 0.60 of overhead per unit would stay with us; buying wins only below about USD 6.70.

The risk in staying is that our plant falls behind on cost; next I would ask two more suppliers to quote and check whether the freed floor space could take a product that earns more.

The numbers to quote: Full cost to buy, including freight and management; Overhead that stays; Breakeven supplier price; Number of capable suppliers.

The figures in the answer come from the illustrative worked example above. In a case, use the client's own numbers.

Classic interview traps

  • Comparing the supplier's price with your full cost. Fixed costs that stay are not saved.
  • Ignoring the cost of managing the supplier: contracts, audits, quality checks, travel.
  • Outsourcing the thing customers choose you for, then finding the supplier sells it to rivals.
  • Forgetting the exit: if the supplier fails or raises prices, how fast can you switch?

Where it is common

Sources

Practise it

Where this move comes up in cases

Related moves