Step-by-step guide to Make or Buy Decision
Manufacturing businesses have to consider cost-lowering decisions on a daily basis. This article will take you through all the basic things you need to know with respect to the vital cost-saving decision known as make-or-buy. You’ll learn 1) what is make-or-buy decision? 2) factors influencing the decision, 3) how to arrive at a make-or-buy decision, and an 4) example.
WHAT IS MAKE-OR-BUY DECISION?
The make-or-buy decision is the action of deciding between manufacturing an item internally (or in-house) or buying it from an external supplier (also known as outsourcing). Such decisions are typically taken when a firm that has manufactured a part or product, or else considerably modified it, is having issues with current suppliers, or has reducing capacity or varying demand.
Another way to define make-or-buy decision that is closely related to the first definition is this: a decision to perform one of the activities in the value chain in-house, instead of purchasing externally from a supplier. A value chain is the complete range of tasks – such as design, manufacture, marketing and distribution of a product / service that businesses must get done to take a service or product from conception to their customers.
Some companies manage all of the tasks in the value chain from manufacturing raw materials all through to the ultimate distribution of the completed goods and provision of after-sales services. Some other companies are happy just to integrate on a smaller scale by buying a lot of the parts and materials that are required for their finished products. When a business is involved in more than one activity in the whole value chain, it is vertically integrated. This kind of integration is quite common.
Vertical integration provides its own set of advantages. An integrated company depends less on its suppliers and so can be certain of a smoother flow of materials and parts for the manufacture than a non-integrated company. In addition, some companies believe they can manage quality better by manufacturing their own parts and materials instead of depending on the quality control standards of external suppliers. What’s more, an integrated company realizes revenue from the parts and material that it is “making” rather than “buying” in addition to income from its usual operations.
The benefits of vertical integration are counterbalanced by the benefits of using outside suppliers. By combining demand from different companie, a supplier can enjoy econoies of scale. These economies of scale can cause better quality and lower expenses than would be possible if the business were to endeavor to manufacture the parts or provide a service by itself. At the same time, a business should be careful to retain control over those tasks that are necessary for maintaining its competitive position. Case in point: Hewlett Packard manages the software for laser printers that it manufactures in collaboration with Canon Inc. of Japan.
In the book “World Class Supply Management” published in 2003, Donald Dobler, Stephen Starling and David Burt provide a rule of thumb for outsourcing. The rule recommends that companies outsource all goods that do not fall into one of the following three classes: 1) the good is critical to the product’s success including customer discernment of key product attributes 2) the good falls well within the firm’s key competencies, or within those the company should develop to accomplish future plans, or 3) the item calls for specialized design and manufacturing equipment or skills.
FACTORS INFLUENCING THE DECISION
To come to a make-or-buy decision, it is essential to thoroughly analyze, all of the expenses associated with product development in addition to expenses associated with buying the product. The assessment should include qualitative and quantitative factors. It should also separate relevant expenses from irrelevant ones and consider only the former. The study should also look at the availability of the product and its quality under each of the two situations.
Introduction to quantitative and qualitative analysis
Quantitative aspects can be calculated and compared whereas qualitative aspects call for subjective judgment and, frequently require multiple opinions. In addition, some of the associated factors can be quantified with sureness while it is necessary to estimate other factors. The make-or-buy decision calls for a thorough assessment from all angles.
Quantitative aspects are essentially the incremental costs stemming from making or purchasing the component. Factors of this type to look at may incorporate things such as availability of manufacturing facilities, needed resources and manufacturing capacity. This may also incorporate variable and fixed expenses that can be found out either by way of estimation or with certainty. Similarly, quantitative expenses would incorporate the cost of the good under consideration as the price is determined by suppliers offering the product for sale in the marketplace.
Qualitative factors to look at call for more subjective assessment. Examples of such factors include control over component quality, the reliability and reputation of the suppliers, the possibility of modifying the decision in the future, the long-term viewpoint concerning manufacture or purchase of the product, and the impact of the decision on customers and suppliers.
Introduction to relevant and irrelevant expenses
As mentioned earlier, distinguishing between these two kinds of expenses is necessary to come to a make-or-buy decision. Relevant costs for manufacturing the good are all the expenses that could be avoided by not manufacturing the product in addition to the opportunity cost resulting from utilizing production facilities to manufacture the good as against the next best alternative utilization of the manufacturing facilities. Relevant costs for buying the product are all the expenses relating to purchasing a product from suppliers. Irrelevant costs are the expenses involved irrespective of whether the good is produced internally or bought externally.
Factors favoring in-house manufacture
- Wish to integrate plant operations
- Need for direct control over manufacturing and/or quality
- Cost considerations (costs less to make the part)
- Improved quality control
- No competent suppliers and/or unreliable suppliers
- Quantity too little to interest a supplier
- Design secrecy is necessary to protect proprietary technology
- Control of transportation, lead time, and warehousing expenses
- Political, environmental, or social reasons
- Productive utilization of excess plant capacity to assist with absorbing fixed overhead (utilizing existing idle capacity)
- Wish to keep up a stable workforce (in times when there are declining sales)
- Greater guarantee of continual supply
Factors favoring purchase from outside
- Suppliers’ specialized know-how and research are more than that of the buyer
- Lack of expertise
- Small-volume needs
- Cost aspects (costs less to purchase the item)
- Wish to sustain a multiple source policy
- Item not necessary to the firm’s strategy
- Limited facilities for a manufacture or inadequate capacity
- Brand preference
- Inventory and procurement considerations
Costs for the make analysis
- Direct labor expenses
- Incremental inventory-carrying expenses
- Incremental capital expenses
- Incremental purchasing expenses
- Incremental factory operating expenses
- Incremental managerial expenses
- Delivered purchased material expenses
- Any follow-on expenses resulting from quality and associated problems
Cost factors for the buy analysis
- Transportation expenses
- Purchase price of the part
- Incremental purchasing expenses
- Receiving and inspection expenses
- Any follow-on expenses associated with service or quality
Though the cost is rarely the sole criterion utilized to come to a make-or-buy decision, easy break-even analysis can be a useful way to quickly guess the expense implications within a decision.
HOW TO ARRIVE AT A MAKE OR BUY DECISION?
Here’s one example of a process of how businesses can make a sensible make-or-buy decision. Businesses should first carry out an assessment of quantitative aspects before considering qualitative aspects to finalize their make or buy decisions.
Carry out the quantitative analysis by comparing the expenses incurred in each option. The expense of purchasing products is the price paid to suppliers to purchase them. On the contrary, the cost of manufacture includes both variable and fixed expenses. For example, a business requires 10 units of its item in 10 consecutive periods. The company can either buy the units at $100 per unit or expend $1,000 to set up manufacture facilities and $8 to manufacture each unit. As the business expends $10,000 to buy the products and $9,000 to manufacture the same quantity of products, with respect to make-or-buy, the business would do better to manufacture the goods, on the basis of only quantitative factors.
Think about all the qualitative factors that may have a bearing on the decision to manufacture the products. This incorporates all pertinent factors that cannot be decreased to numbers such as the quality of the business’ production department and its experience. An example for this is that it may be possible that the business has zero experience in manufacturing a specific good and its previous experience in manufacturing other goods cannot be applied.
Think about qualitative factors that may have a bearing on the decision to buy the products from external suppliers. Such factors include: the quality of the suppliers’ management, its dependability and the quality of its goods. An example for this is that it is probable that the supplier has considerable experience in manufacturing the item being considered and the business may want to develop a long-term relationship with a supplier.
Factor the qualitative aspects into the quantitative assessment so as to complete it. An example for this in this case is that: even though it is cheaper for the business to manufacture its products, there are grounds to believe that its goods would be of a lower grade than those it can buy. In addition, as the business desires to forge a long-term relationship with its supplier, it may desire to purchase its goods from that supplier so as to commence the relationship.
Arrive at a final make-or-buy decision after considering both quantitative and qualitative factors. This would depend on the particular business and what it is doing so as to create profits. Continuing with the above example, even if it is likely that the business may buy better grade products than those it can manufacture in-house, the quality of its goods/products may not have a bearing on its sales on the basis of its business model and what it is putting on the market. If such is the case, the wish to develop a long-term relationship may or may not be adequate to prevail over the $1,000 savings in expenses; instead it depends on how strong is the business’ yearning for the relationship and what it hopes to accomplish by starting it.
Here is a hypothetical example for coming to a make-or-buy decision. A reputable skateboard company is now manufacturing the heavy duty bearing that is utilized in its most liked line of skateboards. The business’ accounting section reports the following expenses for manufacturing 8000 units of the bearings internally every year.
|Allocated general overhead||$5||x||8000||=||$40,000|
|Depreciation of special equipment||$2||x||8000||=||$16,000|
An external supplier offered to sell 8000 bearings to the skateboard company for only $19 per bearing. Should the business cease manufacturing the bearings internally or instead, purchase them from an external supplier? To arrive at a make-or-buy decision, the focus should, at all times, be on the relevant costs (the ones that differ between the alternatives). The expenses that differ between alternatives comprise the expenses that could be prevented by buying the bearings from an external supplier.
If the expenses that can be avoided by buying bearings from the external supplier amount to less than $19, the business must continue to manufacture its bearings and reject the external supplier’s offer. On the other hand, if the expenses that can be prevented by buying the bearings from the external supplier amount to more than $19, the external supplier’s offer should be accepted.
You can use the setup below to manage your applicable/avoidable expenses.
Total applicable/avoidable expense for Making 8000 units:
|Allocated general overhead||not||relevant|
|Depreciation of special equipment||not||relevant|
Total expense for Buying 8000 Units:
|Outside purchase expense||$19||x||8000||=||$152,000|
The difference of $40,000 supports continuing to make 8000 units.
Keep in mind that depreciation of special equipment is mentioned as one of the expenses for manufacturing the bearings internally. Owing to the fact that the equipment has already been bought, this depreciation is a sunken expense and is, therefore, not applicable. If the equipment could be utilized to create another product, this may be a relevant expense as well. Still, we suppose that the equipment has no salvage value and no other use.
In addition, the company is setting aside a part of its general operating expenses, for bearings. Any part of the general operating expenses that would be done away with if the bearings were bought instead of made would be pertinent in this analysis. However, the general operating expenses are possibly a common expense to all the company’s goods produced in the factory and which would continue without changes even if the bearings were bought from outside (is not relevant).
The variable cost (direct labor, direct material and variable overhead) can be prevented if the business does not make the bearing. In addition, we suppose that the supervisor’s salary can also be avoided. This is because at $40,000, it costs less to manufacture the bearings internally than to purchase them from an external supplier.
In conclusion, it may be said, the make-or-buy decision is a very important decision with respect to overall production strategy and the possible implications for asset levels, employment levels and key competencies. Business accounting may appear to be an easy set of equations mirroring the money that enters into a business and that which flows out from it. However, in reality, there are countless intricacies associated with the relationship between various kinds of income and costs. Complexity is particularly obvious in make-or-buy. Considering these aspects, the make-or-buy decision should be weighed with utmost care.
In San Carlos (CA), we meet CEO and Co-Founder of NatureBox, Gautam Gupta. Gautam talks about his …
In San Mateo, we meet CEO & co-founder of Local Motion, John Stanfield. John shares his story …