make versus buy

make vS buy paper ii

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The Make or Buy DecisionA decision concerning whether an item should be produced internally or purchased from an outsidesupplier is called a “make or buy” decision.

Definitions• “Make-or-Buy decisions mean comparison of cost of producing a component or providing the

service internally with the cost of purchasing the component or service from an external supplier”

Make or buy debate is seen by some as an opportunity to thrust forward into a spectacular hi-techinvestment whereas others see it as representing a misguided sense of loyalty to the business’s in-houseteam.

Make versus buy: the wrong decisions cost.

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 opposingbusiness beliefs. Is it a question of optimizing the cost structure, or destroying jobs? Of making fixed costsvariable, 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 anopportunity to thrust forward into a spectacular hi-tech investment. Others see it as representing amisguided sense of loyalty to the business's in-house team. Criteria for an objective decision are neithereasy to find nor easy to apply, since every case is different.

However, the good news is that make or buy considerations can be expressed in objective terms. What isnot such good news is that these considerations have to go much farther and deeper than s normal orconvenient. To be useful, changes in a company's level of integration should make its entire value-addedchain more effective - not just consist of spinning off units or adding on operations or processes in apiecemeal fashion. And when we talk of vertical integration, we include all elements of the chain, not justproduction.

High or low?No amount of observation of prevailing practice in different industries will reveal whether high or lowvertical integration creates competitive advantage. Neither will looking at whether successful companiestend to be less or more vertically integrated.

Research showed that in Germany, successful component manufacturers consistently do more in-houseproduction than less successful ones, while in machinery manufacturing, some of the successful companieshad 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 usedas a means to reinforce existing effectiveness in technology or operations. Thus, if a company istechnologically or operationally superior to its competitors and suppliers, a high level of vertical Integrationwill give it a competitive advantage. If it is weaker, on the other hand, the same level of integration will bea disadvantage.

Outsourcing

• is actually 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.


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• it is a management strategy by which an organisation out sources major non-core functions tospecialised, efficient service providers

Outsourcing to compensate for operational or technological weaknesses only works if the elements thatare farmed out have nothing to do with what differentiates a company in the market. Companies thatoutsource production simply because they are not cost-competitive must be prepared to be overtaken bymore 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 v Outsourcing

• “ if you want the most beautiful lawn in the neighbourhood and you hire someone to take care ofevery aspect of lawn care, including cutting the grass, weed control, watering and fertilising it’soutsourcing. But hiring someone to only cut the lawn is subcontracting.”

Outsourcing versus Insourcing

Outsourcing is purchasing goods and services from outside vendors.

Insourcing is producing goods or providing services within the organization.

A business can cut costs and so lower prices in order to earn a competitive advantage using outsourcing;which is where a business cuts back on its operations to focus on its core activities.

Traditionally a business may have had a number of activities happening on a day-to-day basis, many ofwhich may not have been part of the core business skill sets, so they become transferable and thus asaving for the business.

By buying in these peripheral services from producers who can achieve economies of scale because theyare specialists in 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 differentelements – core and periphery. The change can be clearly seen in the next figure.

Core and Peripheral Elements

CORE

BEFORE Outsourcing

CORE

AFTER Outsourcing


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For e.g. a school might have as its 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 better provided at a lower cost and with a better result than if the school tried tocomplete all the tasks itself.

Component manufacturers rarely achieve strategic differentiation with a superior product concept; theirstrengths 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 dothe less successful.

Machinery companies, on the other hand, are able to achieve adequate differentiation with a superiorsystem 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 machinerymanufacturers is that they are a better judge of their competitive position than poorer performers. Theyaim for high vertical integration when they are strong in operations, but outsource other value-addedstages when their superiority lies more in the machine concept or design.

It is open to question how long this latter strategy will remain sustainable. Today many machines becomecommodities as their life cycles advance, making differentiation possible only through low costs derivedfrom operational efficiency. By this point, at the latest, a manufacturer must be in a position to exploiteconomies of scale and raise its competitive profile by means of superior operational management.

In some cases, such as the 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 raisedifficult social and political concerns. But ignoring the issue could prove fatal, given the strength ofinternational competition. Creative solutions are called for. They might include such moves as spinning offcomponent manufacturing facilities to create Independent companies with their own developmentdepartments as profit centers, or contracting out entire manufacturing stages to suppliers.While reducing vertical integration is not a panacea for low operational efficiency, no company isoperationally 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 ofproduction capacity.

An enterprise may decide to purchase the product rather than producing it, if is cheaper to buy thanmake or if it does not have sufficient production capacity to produce it in-house. With the phenomenalsurge in global outsourcing over the past decades, the make-or-buy decision is one that managers haveto grapple with very frequently.

Factors that may influence a firm's decision to buy a part rather than produce it internally include lack ofin-house expertise, small volume requirements, desire for multiple sourcing, and the fact that the item maynot be critical to its strategy. Similarly, factors that may tilt a firm towards making an item in-house includeexisting idle production capacity, better quality control or proprietary technology that needs to beprotected.


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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 is being asked these questions right now. Executiveshave noticed their peers increasingly relying on outsourcing.

While outsourcing may seem new, it really is just a new focus on the classic make or buy procurementdecision. You need to ensure that such decisions are made intelligently and not just based on theoutsourcing trend.

WHY BUY??

• A firm may decide to buy if it:

1) lacks in-house expertise

2) requires small volumes

3) desires multiple sourcing

4) feels that the item is not critical to its strategy.

5) wants to reduce costs

6) desires to concentrate on core competency

WHY MAKE??

• A firm may 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.

COST FACTOR

• a simple and probably logical rule of thumb when considering whether to make-or-buy is tocarryout 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 is required to make the goods?• What will be our peak demand?• How much risk is associated 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?

What not to buy or outsource

• Management of strategic planning


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• 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 benefits of Outsourcing

• Gain access to world class capabilities• Improve organisational focus• Improved capacity utilization.• Improved product quality• Allows focus 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 is required• Where all services are customised.• Where the employee culture is too 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 – as customer may find out that product x is 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

7 steps to an outsourcing 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


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• 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 reasons for outsourcing

Where the buyer organisation is the main contractor & work is subcontracting 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 is the company’s specialisation? (skill)• For whom have they worked? (ex-clients or current customers)• What part of their capacity is subcontracting? (Strong/weak area)• What is their 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 1980’s & 1990’s• 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


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• Rapid technological changes has enabled subcontracting to provide changes beforecompetition

When To 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 is more financially desirable to buy. If CTB exceeds CTM, the oppositeis true.Make/buy decisions aren’t just about numbers, though.

Questions you absolutely must consider include:

Is this the organization’s core competency?

Could we be harmed by disclosing proprietary information?

What will be the impact on quality or delivery?

What additional risks would 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 asupplier. The choice involves both qualitative (such as quality control) and quantitative (such as therelative cost) factors.

Example:


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Training - Make or Buy Decision

In this: -1. The make decision involves designing and developing a new training course (tailored planned program)

2. The buy option involves using as course either: -Ø Purchased from an ‘inside’ supplierØ Purchased from an ‘outside’ supplier

The choice to make or buy decision depends on following four factors as: -Ø The size of population that needs to be trainedØ The nature of competencies to be trainedØ The timing for training programØ The type of training experience required

Factors Make decision is the mostappropriate when:

Buy decision is the mostappropriate when:

Size of training population Large size and cost fordeveloping course is less pertrainee

Small size anddeveloping cost ofprogram per trainee ismore as compare toreadymade course

Nature of competencies For job specific or companyspecific competencies

For developing generalcompetencies

Timing for training Have long time and alreadycarried out perfect planning.

Quick training needarises.

Type of training experience Good for developing teamspirit, foster behavior andattitude changes, sharingknowledge and experiences,for developing sensitiveinterpersonal issues, etc.

Good for developingoutside the companyknowledge and giving allround information totrainees.

Development cost

These are the costs that are associated with taking the training specification and turning it into effectivetraining program that is ready for delivery and includes the following activities as: -Ø Designing the form and structure of the training.Ø Designing the training materials, e.g. handouts, OHP, training rooms, CBT or WBT, applications forbusiness games, etc.Ø Preparing pre-course materials.Ø Preparing handouts and materials that gives ‘bird eye view’ of training.Ø Preparing evaluation tools.

External consultant who charges fees for it or by internal employees and their managers either carries outall above-mentioned activities.The next step in this is piloting the course at small level of internal employees. Thus if properly developedcosts 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


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basis and it includes the following as: -Ø Cost of trainer(s) – includes external consultants, guest speakers, or cost of using internal training staff.Ø Cost of the venue – training rooms, equipments, catering, accommodation, etc.Ø Cost of duplicated training materials and handouts, and license fees for use of copyright materials.Ø 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: -Ø Costs of trainees’ time due to absence at work, if relevant.Ø Travel and subsistence cost.ACTIVITY #1

• A small international school has to decide whether to subcontract the bussing in of students or toprovide the service themselves. What if the school requires 20 buses and a company called SchoolRun charges U$ 10000 a bus for the year? On the other hand, if the school could buy the 20 busesfrom D&D dealers Inc. for $100000 but faced variable costs of $10000 a bus for fuel and the driver’swages over the year then what is the best option for the school?

Solution• CTB = 20 X 10000 = U$200000• CTM = U$100000 +(U$10000 x 20) = U$300000

In this case CTB < CTM, so the school should outsource.

Activity #2• ABC manufactures part 4A that is used 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 $30 unit 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 accept the supplier’s offer?

Direct materials $ 9 Direct labor 5 Variable overhead 1 Depreciation of special equip. 3 Supervisor's salary 2 General factory overhead 10 Unit product cost 30$

Cost Per Unit Cost of 20,000 Units

Make BuyOutside purchase price $ 25 $ 500,000

Direct materials 9$ 180,000 Direct labor 5 100,000 Variable overhead 1 20,000 Depreciation of equip. 3 - Supervisor's salary 2 40,000 General factory overhead 10 - Total cost 30$ 340,000$ 500,000$

TheThe specialspecial equipmentequipment hashas nono resaleresale valuevalue andand isis aasunksunk cost.cost.


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Activity # 3 (Special Orders)

Jet, Inc. makes a single product whose normal selling price is $20 per unit.




NotNot avoidable;avoidable; irrelevant.irrelevant. IfIf thetheproductproduct isis dropped,dropped, itit willwill bebe

reallocatedreallocated toto otherother products.products.




ShouldShould wewe makemake oror buybuy partpart 4A?4A?Answer:Answer: Make!Make!

DECISION RULEIn deciding whether to accept the outside supplier’s offer,ABC isolated the relevant costs of making the part byeliminatingeliminating:

The sunk costs (depreciation)

The future costs that will not differ between makingor buying the parts (common costs)


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A foreign distributor offers to purchase 3,000 units for $10 per unit. This is a one-time order that would not affect the company’s regular business. Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units.

Should Jet accept the offer?

Activity # 4:

Northern Optical ordinarily sells the X-lens for $50. The variable production cost is$10, the fixed production cost is $18 per unit, and the variable selling cost is $1.A customer has requested a special order for 10,000 units of the X-lens to beimprinted with the customer’s logo. This special order would not involve anyselling costs, but Northern Optical would have to purchase an imprintingmachine for $50,000.What is the rock bottom minimum price below which Northern Optical shouldnot go in its negotiations with the customer? In other words, below what pricewould Northern Optical actually be losing money on the sale? There is ampleidle capacity to fulfill the order.a. $50b. $10c. $15

Jet, Inc.Contribution Income Statement

Revenue (5,000 × $20) 100,000$ Variable costs: Direct materials 20,000$ Direct labor 5,000 Manufacturing overhead 10,000 Marketing costs 5,000 Total variable costs 40,000 Contribution margin 60,000 Fixed costs: Manufacturing overhead 28,000$ Marketing costs 20,000 Total fixed costs 48,000 Net operating income 12,000$

$8$8 variablevariable

If Jet accepts the offer, net operating income will increase by $6,000.

Increase in revenue (3,000 × $10) 30,000$ Increase in costs (3,000 × $8 variable cost) 24,000 Increase in net income 6,000$

Note: This answer assumes that fixed costs are unaffected by the order and thatvariable marketing costs must be incurred on the special order.


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d. $29

Solution:

VariableVariable productionproduction costcost $100,000$100,000AdditionalAdditional fixedfixed costcost 50,00050,000TotalTotal relevantrelevant costcost $150,000$150,000NumberNumber ofof unitsunits 10,00010,000AverageAverage costcost perper unitunit $15$15

make versus buy

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