Make Versus Buy

make vS buy paper ii
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The Make orBuy Decision
A decisionconcerning whetheranitemshould be produced internally orpurchased fromanoutside
supplieriscalled a make orbuydecision.
Definitions
Make-or-Buy decisionsmeancomparisonof costof producing a componentorproviding the
service internally withthe costof purchasing the component orservice fromanexternal supplier
Make or buy debate is seen by some as an opportunity to thrust forward into a spectacular hi-tech
investment whereas others see it asrepresenting a misguided sense of loyalty to the businesssin-house
team.
Make versusbuy: the wrong decisionscost.
Discussions on vertical integration - about whether products, parts, or services should be produced in-
house or outsourced - can often become heated exchanges between managers holding opposing
business beliefs. Isit a question of optimizing the cost structure, or destroying jobs? Of making fixed costs
variable, or losing know how? Of gaining flexibility, or plunging into dependence?
Not surprisingly, the make or buy, debate almost invariably runs into contentious areas. Some see in it an
opportunity to thrust forward into a spectacular hi-tech investment. Others see it as representing a
misguided sense of loyalty to the business's in-house team. Criteria for an objective decision are neither
easy to find nor easy to apply, since every case is different.
However, the good news isthat make or buy considerations can be expressed in objective terms. What is
not such good newsisthat these considerations have to go much farther and deeper than snormal or
convenient. To be useful, changes in a company's level of integration should make its entire value-added
chain more effective - not just consist of spinning off units or adding on operations or processes in a
piecemeal fashion. And when we talk of vertical integration, we include all elements of the chain, not just
production.
High or low?
No amount of observation of prevailing practice in different industries will reveal whether high or low
vertical integration creates competitive advantage. Neither will looking at whether successful companies
tend to be lessor more vertically integrated.
Research showed that in Germany, successful component manufacturers consistently do more in-house
production than less successful ones, while in machinery manufacturing, some of the successful companies
had high vertical integration and some low.
Western auto makers are traditionally highly integrated, though now tending to reduce integration,
conversely, in plant construction; the most successful companies have very low vertical integration.
Clearly, every company must find its own optimum level of Integration. Vertical integration should be used
asa means to reinforce existing effectiveness in technology or operations. Thus, if a company is
technologically or operationally superior to its competitors and suppliers, a high level of vertical Integration
will give it a competitive advantage. If it is weaker, on the other hand, the same level of integration will be
a disadvantage.
Outsourcing
isactually a wider term than make-buy and the two terms can be used synonymously.
It involves the strategic use of resources to perform activities traditionally handled by internal staff
and their resources.
it is a management strategy by which an organisation out sources major non-core functions to
specialised, efficient service providers
Outsourcing to compensate for operational or technological weaknesses only works if the elements that
are farmed out have nothing to do with what differentiates a company in the market. Companies that
outsource production simply because they are not cost-competitive must be prepared to be overtaken by
more efficient competitors, or even by their suppliers entering the market in direct competition.
Subcontracting
may be distinguished from outsourcing:
Is a short term approach or activity or function.
Sub contracting vOutsourcing
if you want the most beautiful lawn in the neighbourhood and you hire someone to take care of
every aspect of lawn care, including cutting the grass, weed control, watering and fertilising its
outsourcing. But hiring someone to only cut the lawn issubcontracting.
Outsourcing versusInsourcing
Outsourcing is purchasing goods and services from outside vendors.
Insourcing isproducing goods or providing services within the organization.
A businesscancutcostsand so lowerpricesinorder to earna competitive advantage using outsourcing;
whichiswhere a businesscutsback onitsoperationsto focusonitscore activities.
Traditionally a business may have had a number of activitieshappening on a day-to-day basis, many of
which may not have been part of the core business skill sets, so they become transferable and thus a
saving for the business.
By buying in these peripheral servicesfrom producers who can achieve economiesof scale because they
are specialistsin that particular service, the main business can reduce costs.
Lets understand this concept with the help of a diagram:
Imagine that the costs of a business can be represented by circles and comprise the two different
elements core and periphery. The change can be clearly seen in the next figure.
Core and Peripheral Elements
CORE
BEFORE Outsourcing
CORE
AFTER Outsourcing
For e.g. a school might have asits core activity teaching, but it can then outsource such services as:
Catering
Transport
Duties and invigilation
Coaching
Expeditions
Staff training
Recruitment
Security
Maintenance
Cleaning
All of these could be betterprovided at a lowercostand with a betterresult than if the school tried to
complete all the tasks itself.
Component manufacturers rarely achieve strategic differentiation with a superior product concept; their
strengths are more likely to lie in operational excellence, larger economies of scale, a superior process,
and first-rate logistics. As a result, the best among them tend to have higher levels of integration than do
the less successful.
Machinery companies, on the other hand, are able to achieve adequate differentiation with a superior
system architecture or design, and have no real need for particular operational strengths. To some extent,
they can compensate for operational weaknesses by outsourcing. What distinguishes excellent machinery
manufacturers is that they are a better judge of their competitive position than poorer performers. They
aim for high vertical integration when they are strong in operations, but outsource other value-added
stageswhen their superiority liesmore in the machine concept or design.
It is open to question how long this latter strategy will remain sustainable. Today many machines become
commodities as their life cycles advance, making differentiation possible only through low costs derived
from operational efficiency. By this point, at the latest, a manufacturer must be in a position to exploit
economies of scale and raise its competitive profile by means of superior operational management.
In some cases, such asthe automotive industry, optimizing vertical Integration actually means reducing it,
only in this way can companies make the necessary 30 to 40 percent cost reductions. This can raise
difficult social and political concerns. But ignoring the issue could prove fatal, given the strength of
international competition. Creative solutions are called for. They might include such moves as spinning off
component manufacturing facilities to create Independent companies with their own development
departments as profit centers, or contracting out entire manufacturing stagesto suppliers.
While reducing vertical integration isnot a panacea for low operational efficiency, no company is
operationally superior...
The act of choosing between manufacturing a product in-house or purchasing it from an external supplier.
In a make-or-buy decision, the two most important factors to consider are cost and availability of
production capacity.
An enterprise may decide to purchase the product rather than producing it, if is cheaper to buy than
make or if it does not have sufficient production capacity to produce it in-house. With the phenomenal
surge in global outsourcing over the past decades, the make-or-buy decision isone that managers have
to grapple with very frequently.
Factors that may influence a firm's decision to buy a part rather than produce it internally include lack of
in-house expertise, small volume requirements, desire for multiple sourcing, and the fact that the item may
not be critical to its strategy. Similarly, factors that may tilt a firmtowards making an item in-house include
existing idle production capacity, better quality control or proprietary technology that needs to be
protected.
Are we outsourcing enough? What functions can we move to China? Are we doing business with India yet?
It is likely that a procurement manager somewhere isbeing asked these questions right now. Executives
have noticed their peers increasingly relying on outsourcing.
While outsourcing may seem new, it really isjust a new focus on the classic make or buy procurement
decision. You need to ensure that such decisions are made intelligently and not just based on the
outsourcing trend.
WHYBUY??
A firmmay decide to buy if it:
1) lacks in-house expertise
2) requires small volumes
3) desires multiple sourcing
4) feels that the item isnot critical to its strategy.
5) wants to reduce costs
6) desires to concentrate on core competency
WHYMAKE??
A firmmay decide to make or produce an item in-house if:
1) existing production capacity is underutilized.
2) it wants to have better quality control.
3) it wants to protect proprietary technology.
COSTFACTOR
a simple and probably logical rule of thumb when considering whether to make-or-buy isto
carryout a comparison of cost of making ourselves with buying in.
A number of questions need answering before deciding whether to make-or-buy: -
What volume do we expect to require?
What capital investment isrequired to make the goods?
What will be our peak demand?
How much risk isassociated with the technology required?
How much waste or cost of rework can be expected?
What level of inventory will we or our supplier hold?
What variations in material costs can be expected?
Can we make more by concentrating on our special competencies than we can save by carrying
out the work internally?
Whatnotto buy oroutsource
Management of strategic planning
Management finances
Control of suppliers
Quality & environmental management
Supervision of regulatory requirements, product liability, environmental regulations, staff health &
safety, public safety product & services safety
Some benefitsof Outsourcing
Gain access to world class capabilities
Improve organisational focus
Improved capacity utilization.
Improved product quality
Allowsfocus on core competencies.
Free management time
Reduce staff costs
Increased flexibility
Cost certainty
Improved service levels
Reduced capital requirement
Reduced risk
Some problems with outsourcing
Specific or unique knowledge of the business isrequired
Where all services are customised.
Where the employee culture istoo fragmented or hostile for the organisation to come back
together
Other problems with outsourcing
Long term commitment
Different corporate (and national) culture
Dependence on suppliers
Additional training
Reduction in flexibility
Coordinating different suppliers
Dilution of brand ascustomer may find out that product xis not produced by company Y.
Quality of service
High staff turnover
Communication problems different languages and time zones.
Lack of commitment to client or industry
Lack of control over larger suppliers
7stepsto anoutsourcing decision
Want to produce goods ourselves No
Can we licence technology etc. No
Can we buy from best suppliers No
Can we establish joint development project No
Can we enter long term development or purchase agreement No
Can we acquire best in the world supplier No
Can we establish effective management of supplier Yes
OUTSOURCE
Measuring outsourcing performance
Response time
Downtime (job not done due to technical or human failures)
Turnaround time or schedule performance
Performance reports
Satisfactory performance statement
Penalties for non performance
Some reasonsforoutsourcing
Where the buyer organisation is the main contractor & work issubcontracting due to:
Over loading of machinery or labour
Meeting time deadline
Lack of specialist machinery or knowledge
Wishing to avoid acquiring long-term capacity when future demand uncertain
Cheaper to subcontract than manufacture internally
Selecting a subcontractor
What isthe companysspecialisation? (skill)
For whom have they worked? (ex-clients or current customers)
What part of their capacity issubcontracting? (Strong/ weak area)
What istheir capacity in terms of plant & output? (handling size and results)
Are their workforce permanent and well trained?
What are their industrial relations record? (market news & update)
Have they been approved for government work? (necessary licences, approvals)
More key questions
Are quality systems adequate?
Are standards of work good?
How reliable are they at meeting targets?
Are they adequately financed?
Own Transportation?
Do they subcontract themselves ?
Some examples of outsourced services
Car park management
Cleaning
Catering
Building maintenance
Security
Transport management
Waste disposal
Library
Medical/ Welfare
Pest control
Ground maintenance
Computers & information technology
How subcontracting evolved.
Dramatic increase in subcontracting since 1980s& 1990s
Certain activities in public sector were required to go to competitive tender
Many large organisations decided to stick to the knitting concentrate on core competencies
and divest peripheral activities
Rapid technological changes has enabled subcontracting to provide changes before
competition
WhenTo Outsource?
We know that this decision depends on cost:
When dealing with this decision there are 4 numbers you need to know:
Your volume
The fixed costs associated with making (e.g. the tooling that must be bought)
The per-unit direct costs of making
The per-unit landed cost from a supplier
So, you plug these numbers into a couple of formulas:
CTB=V* LC and CTM=FC +(PUDC * V)
Where,
CTB =Cost To Buy
V =Volume
LC =Supplier's Per Unit Landed Cost
CTM =Cost To Make
FC =Fixed Costs (of making)
PUDC =Per Unit Direct Cost (of making)
If CTM exceeds CTB, then it ismore financially desirable to buy. If CTBexceeds CTM, the opposite
is true.
Make/buy decisions arent just about numbers, though.
Questions you absolutely must consider include:
Isthis the organizationscore competency?
Could we be harmed by disclosing proprietary information?
What will be the impact on quality or delivery?
What additional riskswould we be facing?
How irreversible is the decision?
Determination of whether it is more advantageous to make a particular item in-house, or to buy it from a
supplier. The choice involves both qualitative (such asquality control) and quantitative (such as the
relative cost) factors.
Example:
Training - Make orBuy Decision
In this: -
1. The make decision involvesdesigning and developing a new training course (tailored planned program)
2. The buy option involvesusing ascourse either: -
Purchased from an inside supplier
Purchased from an outside supplier
The choice to make or buy decision depends on following four factors as: -
The size of population that needs to be trained
The nature of competencies to be trained
The timing for training program
The type of training experience required
Factors Make decisionisthe most
appropriate when:
Buy decisionisthe most
appropriate when:
Size of training population Large size and cost for
developing course isless per
trainee
Small size and
developing cost of
program per trainee is
more as compare to
readymade course
Nature of competencies For job specific or company
specific competencies
For developing general
competencies
Timing for training Have long time and already
carried out perfect planning.
Quick training need
arises.
Type of training experience Good for developing team
spirit, foster behavior and
attitude changes, sharing
knowledge and experiences,
for developing sensitive
interpersonal issues, etc.
Good for developing
outside the company
knowledge and giving all
round information to
trainees.
Development cost
These are the costs that are associated with taking the training specification and turning it into effective
training program that is ready for delivery and includes the following activities as: -
Designing the form and structure of the training.
Designing the training materials, e.g. handouts, OHP, training rooms, CBTor WBT, applications for
business games, etc.
Preparing pre-course materials.
Preparing handouts and materialsthat gives bird eye view of training.
Preparing evaluation tools.
External consultant who charges fees for it or by internal employees and their managers either carries out
all above-mentioned activities.
The next step in this is piloting the course at small level of internal employees. Thus if properly developed
costs makes this pilot training successful, then it will be easy to train other employees in the organization.
Delivery cost
These are those costs associated with delivering a developed course and are compiled on a per course
basisand it includes the following as: -
Cost of trainer(s) includes external consultants, guest speakers, or cost of using internal training staff.
Cost of the venue training rooms, equipments, catering, accommodation, etc.
Cost of duplicated training materials and handouts, and license fees for use of copyright materials.
Administrative cost involved with making the arrangements for the course, trainers, and for trainees.
In addition, there are common costs related with trainees, which includes: -
Costs of trainees time due to absence at work, if relevant.
Travel and subsistence cost.
ACTIVITY#1
A small international school has to decide whether to subcontract the bussing in of students or to
provide the service themselves. What if the school requires 20 buses and a company called School
Run charges U$ 10000a bus for the year? On the other hand, if the school could buy the 20 buses
from D&D dealersInc. for $100000 but faced variable costs of $10000 a bus for fuel and the drivers
wages over the year then what isthe best option for the school?
Solution
CTB=20 X 10000 =U$200000
CTM =U$100000 +(U$10000 x20) =U$300000
In this case CTB<CTM, so the school should outsource.
Activity #2
ABC manufactures part 4A that isused in one of its products.
The unit product cost of this part is:
The special equipment used to manufacture part 4A has no resale value.
The total amount of general factory overhead, which is allocated on the basis of direct labor hours,
would be unaffected by this decision.
The $30unit product cost is based on 20,000 parts produced each year.
An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.
Should we acceptthe suppliersoffer?
Di rect materi al s $ 9
Di rect l abor 5
Vari abl e overhead 1
Depreci ati on of speci al equi p. 3
Supervi sor's sal ary 2
General factory overhead 10
Uni t product cost 30 $
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outsi de purchase price $ 25 $ 500,000
Direct materials 9 $ 180,000
Direct labor 5 100,000
Vari abl e overhead 1 20,000
Depreci ati on of equi p. 3 -
Supervi sor's salary 2 40,000
General factory overhead 10 -
Total cost 30 $ 340,000 $ 500,000 $
The The special special equipment equipment has has no no resale resale value value and and is is a a
sunk sunk cost. cost.
Activity #3(Special Orders)
J et, Inc. makes a single product whose normal selling price is $20 per unit.
Cost
Per
Uni t Cost of 20,000 Units
Make Buy
Outsi de purchase pri ce $ 25 $ 500,000
Di rect materi als 9 $ 180,000
Di rect labor 5 100,000
Variabl e overhead 1 20,000
Supervi sor's sal ary 2 40,000
Total cost 30 $ 340,000 $ 500,000 $
Not Not avoidable; avoidable; irrelevant. irrelevant. If If the the
product product is is dropped, dropped, it it will will be be
reallocated reallocated to to other other products. products.
Cost
Per
Unit Cost of 20,000 Uni ts
Make Buy
Outsi de purchase pri ce $ 25 $ 500,000
Di rect materi al s 9 $ 180,000
Di rect l abor 5 100,000
Vari abl e overhead 1 20,000
Supervi sor's sal ary 2 40,000
Total cost 30 $ 340,000 $ 500,000 $
Should Should we we make make or or buy buy part part 4A? 4A?
Answer: Answer: Make! Make!
DECISION RULE
In deciding whether to accept the outside suppliers offer,
ABC isolated the relevant costs of making the part by
eliminating eliminating:
The sunk costs (depreciation)
The future costs that will not differ between making
or buying the parts (common costs)
A foreign distributor offers to purchase 3,000 units for $10 per unit.
This is a one-time order that would not affect the companysregular business.
Annual capacity is10,000 units, but J et, Inc. iscurrently producing and selling only 5,000 units.
Should J etaccept the offer?
Activity #4:
Northern Optical ordinarily sellsthe X-lensfor $50. The variable production cost is
$10, the fixed production cost is $18per unit, and the variable selling cost is $1.
A customer hasrequested a special order for 10,000units of the X-lensto be
imprinted with the customers logo. This special order would not involve any
selling costs, but Northern Optical would have to purchase an imprinting
machine for $50,000.
What is the rock bottomminimumprice below which Northern Optical should
not go in its negotiationswith the customer? In other words, below what price
would Northern Optical actually be losing money on the sale? There isample
idle capacity to fulfill the order.
a. $50
b. $10
c. $15
Jet, Inc.
Contri buti on Income Statement
Revenue (5,000 $20) 100,000 $
Vari abl e costs:
Di rect materi al s 20,000 $
Di rect l abor 5,000
Manufacturi ng overhead 10,000
Marketi ng costs 5,000
Total vari abl e costs 40,000
Contri buti on margi n 60,000
Fi xed costs:
Manufacturi ng overhead 28,000 $
Marketi ng costs 20,000
Total fi xed costs 48,000
Net operati ng i ncome 12,000 $
$8 $8 variable variable
If Jet accepts the offer, net operating income will increase by $6,000.
Increase i n revenue (3,000 $10) 30,000 $
Increase i n costs (3,000 $8 vari abl e cost) 24,000
Increase i n net i ncome 6,000 $
Note: This answer assumes that fixed costs are unaffected by the order and that
variable marketing costs must be incurred on the special order.
d. $29
Solution:
Variable Variable production production cost cost $100,000 $100,000
Additional Additional fixed fixed cost cost 50,000 50,000
Total Total relevant relevant cost cost $150,000 $150,000
Number Number of of units units 10,000 10,000
Average Average cost cost per per unit unit $15 $15

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