Pricing and make-or-buy decisions

Learning goals

• Build a short-run floor and long-run target price.
• Compare internal avoidable cost with supplier cost and opportunity value.
• Quantify break-even supplier or volume thresholds and assess strategic risk.

Prerequisite check

For one order using idle capacity, incremental cost may guide a floor. Over the long run, price must also support capacity, product development, service, and required return. “Cost plus” is useful only when the chosen cost base and market reality are understood.

Vocabulary

• Target costing: allowable cost = market price − required profit.
• Cost-plus price: cost base plus a stated markup.
• Make-or-buy: sourcing decision comparing internal and external alternatives.
• Supplier switching cost: qualification, transition, tooling, disruption, or exit cost.
• Strategic dependency: loss of capability or bargaining power from outsourcing.

Core idea

Pricing and sourcing use relevant costs but ask different strategic questions. A low supplier quote may not save allocated fixed cost, and a high accounting product cost may include common amounts unchanged by the decision. Capacity released has value only if there is a feasible alternative use.

Why this treatment makes sense

Full-cost thinking protects long-run sustainability; contribution thinking protects good short-run opportunities. Combining them with market demand and capability avoids both underpricing and keeping inefficient work for emotional reasons.

A repeatable method

1. Define time horizon, demand, capacity, quality, and required return.
2. For pricing, calculate relevant floor and full-cost/target benchmarks.
3. For sourcing, total avoidable internal materials, labour, overhead, and opportunity cost.
4. Compare supplier price plus freight, inspection, transition, and risk-adjusted costs.
5. Exclude unavoidable allocations and sunk equipment.
6. Calculate break-even supplier price/volume.
7. Decide conditionally and specify supplier/service controls and review dates.

Worked example

Lakeshore Pumps needs 8,000 valves. Per valve internal costs: materials $9, labour $6, variable overhead $3, allocated fixed overhead $7. Of fixed overhead, $20,000 supervisor salary is avoidable; the remaining $36,000 allocation continues. Supplier offers $22 per valve, delivered. Freed capacity could earn $18,000 contribution.

Relevant make cost = 8,000 × ($9 + $6 + $3) + $20,000 + $18,000 opportunity cost = $182,000. Buy cost = 8,000 × $22 = $176,000. Buying is $6,000 better before transition, quality, and dependency effects. The $36,000 unavoidable allocation is excluded.

Break-even supplier price = $182,000/8,000 = $22.75. A $10,000 qualification cost would reverse the first-year choice: adjusted buy $186,000, so make is $4,000 better.

Journal, ledger, and statement connection

Decision schedules do not remove fixed assets or overhead accounts automatically. Accepted purchases enter inventory/AP normally; avoided salaries require actual staffing actions. Post-decision reports compare promised savings, defects, lead time, and capacity use.

Common mistakes

• Including all allocated fixed overhead as avoidable.
• Claiming capacity opportunity cost without a feasible alternative.
• Setting a long-run price from variable cost alone.
• Ignoring supplier currency, quality, cybersecurity, IP, or continuity risk.

Guided practice

10,000 parts: avoidable make cost $150,000; supplier $14.40 each plus $8,000 inspection; no alternative use. Buy $152,000, so make saves $2,000. Small difference increases the importance of sensitivity and qualitative risk.

Independent practice

Level 1 — target cost: Market price $120; required profit 25% of selling price. Find allowable cost.

Level 2 — source: 5,000 units; avoidable internal $17/unit plus $12,000 avoidable fixed; supplier $20/unit plus $3,000 transition. Compare.

Level 3 — strategy: Outsourcing saves $30,000 but transfers a proprietary process to one supplier. Recommend safeguards and a decision condition.

Self-check and solutions

Level 1: Required profit $30; allowable cost $90.

Level 2: Make $85,000 + $12,000 = $97,000. Buy $100,000 + $3,000 = $103,000. Make saves $6,000.

Level 3: Consider IP clauses, dual sourcing, audit rights, quality/service levels, tooling ownership, exit plan, and staged volumes. Outsource only if risk controls and risk-adjusted benefit exceed a stated threshold.

Retrieval practice

1. State target-cost formula.
2. Are continuing allocations relevant to buy?
3. When does released capacity create opportunity value?

Answers: market price − required profit; no; when a feasible profitable use is forgone.

Exam-style application

Calculate target cost and a make-or-buy comparison, find the break-even quote, test one risk scenario, and write a conditional recommendation with post-decision measures.

Lesson summary

Strong pricing and sourcing decisions combine relevant cash flows, long-run economics, market evidence, capability, and enforceable risk controls.