Make or Buy: The Make-or-Buy Decision in a Small Business

Why the make-or-buy question keeps coming up in small businesses

A small business asks this question more often than it realizes. Should bookkeeping stay in-house or go to the tax accountant? Do we make the component ourselves or buy it? Does an employee maintain the website on the side, or does an agency take over? Usually the question is not decided; it decides itself: because someone happens to have time, it is done in-house, and because a cheap offer comes along, it is bought in.

So the question is: by which criteria should a small business decide whether to do a task itself or buy it in? To answer it, we first clarify the terms, then present transaction cost theory as a mental model, look at what a study of small firms shows, weigh two perspectives, and finally arrive at a calculation and a checklist.

If you only compare the quoted price with your own hourly rate, you are comparing two numbers that are both wrong.

Terms: in-house work, buying in, and the costs in between

Make or buy refers to the decision whether a company provides a service itself or buys it from another company. Handing over a task previously done in-house is called outsourcing. Between the two poles there are hybrid forms: a fixed partnership, a framework agreement, or sharing capacity with another business.

Three types of cost matter for the comparison. The costs of doing it yourself include working time, materials, tools, and software. How to value working time properly is described in the guide what a process costs: minutes per run times cost per minute of practically usable time, which that guide sets at 80 percent of paid time. The price of buying in is what is in the quote. On top come transaction costs, meaning the costs of searching for, negotiating with, coordinating, and monitoring the partner.

A fourth quantity is overlooked most often: the costs that remain despite buying in. If you outsource payroll but keep the employee, you do not save her salary. You save it only if she uses the time gained for other work that would otherwise be bought in or left undone. This corresponds to the distinction in the guide contribution margin per order: for short-term decisions, only the costs that actually change as a result of the decision count.

The mental model: transaction cost theory in three questions

Transaction cost theory goes back to Ronald Coase and was elaborated by Oliver Williamson. Its basic idea: every exchange in the market causes further costs beyond the price, namely for finding a partner, for negotiating and concluding the contract, and for checking whether delivery is as agreed. These costs help determine whether a deal is worthwhile. According to this model, a company does a task itself when the costs of steering it through the market would be higher than the costs of its own organization.

When that is the case depends, according to the theory, on a few characteristics of the task. Everaert, Sarens, and Rommel (2010), following Klein (2005), summarize them as follows: transactions differ in how many assets they require that are useful only in this relationship, how much uncertainty there is about the future and about the partner's behavior, and how often they occur. From this, three test questions for the business can be derived.

1. How specific is the task?

   A task is specific if it requires knowledge, tools, or processes that are useful only in your business. A partner would first have to build them and could later exploit the dependence. High specificity speaks for doing it yourself.

2. How uncertain is it?

   A task is uncertain if its scope and requirements are hard to predict or if it is hard to check whether the partner is doing good work. Then a lot has to be renegotiated and monitored. High uncertainty tends to speak for doing it yourself.

3. How often does it occur?

   A task that occurs daily justifies your own people and processes more than one that comes up twice a year. Rare tasks are better bought from someone who does them often.

The economist Williamson also showed why contracts can never cover everything, as the guide order confirmation describes. The more remains open in an outsourced task, the more depends on trust and renegotiation. The same model also explains when an in-house field sales force makes more sense than independent sales agents, as the case study Würth shows with Anderson's (1985) study.

What a study of small firms shows

Everaert, Sarens, and Rommel (2010) examined why some small and medium-sized firms in Belgium outsource their accounting and others do not. They distinguished routine tasks, such as entering invoices and interim reporting, from non-routine tasks, such as preparing the annual accounts. The authors stress that research on outsourcing services in small firms had been rare until then, even though such firms account for a large part of the economy.

The results support the theory on key points. For routine tasks, outsourcing was significantly related to frequency; for non-routine tasks, to frequency and specificity. In both cases: frequent tasks were outsourced less often, as were tasks with high specificity. Two further findings go beyond the theory. The owner's trust in the external accountant was related to outsourcing, and owners with a higher level of education outsourced less often, both routine and non-routine tasks.

For an owner, the finding about the decision-maker is notable. The decision follows not only the characteristics of the task but also the person deciding. That is not a mistake, but it is a reason to examine your own inclination openly: do you keep a task because it is specific, or because you like having it in your own hands?

Two perspectives: core business or cost comparison?

The first perspective puts the core business at the center. It goes back to the debate on strategic outsourcing shaped by Quinn and Hilmer (1994) and to the observation that companies increasingly concentrate on their core activities. A business should do itself what sets it apart from the competition and buy everything else from specialists who can do it better and more cheaply.

The second perspective is more sober. It does not ask what belongs to the core but calculates: what does the task really cost in-house, and what does buying in cost with all side costs? In its favor is that the term core business is elastic and is readily used to justify a decision that has already been made.

I consider both perspectives necessary, but in a fixed order. First, the three questions of transaction cost theory clarify whether a task is suitable for the market at all. A highly specific, uncertain, and frequent task belongs in the business, whatever the offer costs. Only for tasks that pass the market test does the cost comparison decide. The question of the core business is a good check question, but no substitute for the calculation.

The calculation: a worked example with all costs

A worked example with freely chosen numbers: a business has so far done its ongoing bookkeeping itself. An employee needs 120 hours a year for it. At a cost rate of 0.85 euros per minute of practically usable time, as in the guide on process costs, that is about 6,120 euros. Add 600 euros for software. A tax accounting firm offers to do the task for 4,800 euros a year. For collecting receipts, queries, and checking, the owner expects 15 hours a year, or a good 765 euros.

The example shows two mistakes that are common in practice. The first is comparing 6,720 euros with 4,800 euros. It omits coordination and makes buying in look about 1,900 euros cheaper instead of a good 1,100 euros. The second mistake is harder to see: if the employee stays in the business and the freed time is not used sensibly, only the 600 euros for software disappear. Then buying in costs about 4,965 euros extra per year.

In the example, buying in therefore only pays off when the 120 hours go into work that yields more than bookkeeping, such as order processing or following up on quotes. That is the real question behind every make-or-buy calculation: what does the business do with the capacity that is freed up?

The checklist: make or buy in six steps

• Describe the task precisely: scope, frequency, required knowledge, and interfaces with other processes.
• Answer the three questions: how specific, how uncertain, how frequent? If all three are high, the task stays in-house.
• Value the in-house work at the costs that actually change with the decision, and write the full costs next to them.
• Calculate buying in with the quoted price, one-off costs for search and handover, and ongoing coordination.
• Decide what will happen with the freed time before the decision is made.
• Check the partner and arrange an exit: notice period, handover of data and documents, cover.

The last point is often underestimated. An outsourced task creates dependence, and the more specific it is, the more expensive a switch becomes. How to check a business partner before working together is described in the guide due diligence on business partners. How suppliers are then assessed on an ongoing basis is shown in the guide evaluating suppliers.

Conclusion: when a small business makes and when it buys

To answer the guiding question: a small business should do a task itself when it is specific to the business, hard to predict or monitor, and occurs frequently. These are the three characteristics of transaction cost theory, and the study by Everaert, Sarens, and Rommel (2010) supports two of them for small firms. For tasks that occur rarely and require little business knowledge, the cost comparison decides, and it must include all costs: coordination and monitoring when buying in, and the costs that actually disappear when doing it in-house.

The limits are clear. The theory describes tendencies, not formulas, and the study cited concerns one function in one country. The most important practical lesson is therefore independent of any study: buying in is only cheaper if the business knows what it will do with the time gained.