Make or Buy

(Subcontract) Decision
• Decision: whether or not a company is
going to produce (make) a product/service
in its internal facility or to buy (outsource,
subcontract) that product/service from an
outside vendor.
• Major criterion: single monetary value
(dollar, rupiah).

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 Example
• An automotive company has been
subcontracting a spare part of its car production
to a nearby contractor. The contractor charges
$45 for each unit of that spare part. The
automotive company estimates that this spare
part could actually be produced internally for $20
per unit. However, the necessary plant
expansion and purchasing of the new equipment
would cost about $6 million. Should the
company undertake the expansion?

2
 Make or Buy Decision: BEP
• Price per unit offered by the contractor: $c.
• Cost per unit if produced internally: $d
• Investment cost if produced internally: $K
• Number of product to be produced: x units
• Break even point:
K + dx = cx
x = K/(c-d)
• BEP = 6.000.000/(45-20)= 240.000 units
3
Cost Buy cost = cx

Make cost = K + dx

x = K/(c-d)

BEP Units (x)

4
Make or Buy Decision: Payback Period
• Suppose the management of the
automotive company estimates that
demand for that spare part will be 65,000
units a year. They further estimate that the
investment will have an economic life of
about six years. The CEO uses a payback
of 3.5 years as her cutoff for new
investment. Should the company produced
this spare part internally?

5
Make or Buy Decision: Payback Period

• Let the number of demand per year: D

units
• Payback = K/[(c-d)D]
• Payback = 6,000,000/[(45-20)65,000] =
3.69 years. This is slightly worse than the
CEO’s standard (3.5 years).

6
 Make or Buy Decision: IRR
• Suppose the vice president of the
automotive company decides that it might
be interesting to calculate the internal
rate of return (IRR) for the proposed
internal spare part production.
• Saving per unit = $45 - $20 = $25
• Savings per year = $25/unit x 65,000 =
1.625 million.

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 Calculating IRR
• IRR occurs when net present value (NPV)
equals zero (NPV = 0).
1.625 1.625 1.625 1.625 1.625 1.625

0 1 2 3 4 5 6

1.625 1.625 1.625 1.625 1.625 1.625

-6      0
(1  r) (1  r) (1  r) (1  r) (1  r) (1  r) 8
1 2 3 4 5 6
• If the management (CEO) had a minimum
attractive rate of return (MARR) less than
16%, then, the proposal of producing the
spare part internally can be attractive. In
other words, if the IRR of the proposed
investment (‘make in-house’) is less than
the management’s MARR, then this
proposal would be less attractive,
especially if there were competing
proposals in light of limited budget
available.
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 Calculating IRR using Excel
• Use IRR function in the Excel:
• =IRR (values, [guess])
• =IRR (A1:A7,30) A
1 -6
= 16% 2 1.625
3 1.625
4 1.625
5 1.625
6 1.625
7 1.625
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