Make or Buy Analysis

The make-or-buy decision is the act of making a strategic choice between producing an item internally (in-house) or buying it externally (from an outside supplier). The buy side of the decision also is referred to as outsourcing. Make-or-buy decisions usually arise when a firm that has developed a product or part—or significantly modified a product or part—is having trouble with current suppliers, or has diminishing capacity or changing demand.

Make-or-buy analysis is conducted at the strategic and operational level. Obviously, the strategic level is the more long-range of the two. Variables considered at the strategic level include analysis of the future, as well as the current environment. Issues like government regulation, competing firms, and market trends all have a strategic impact on the make-or-buy decision. Of course, firms should make items that reinforce or are in-line with their core competencies. These are areas in which the firm is strongest and which give the firm a competitive advantage.

Make or buy is a valid consideration in any cost reduction or product improvement program. Advantages and disadvantages of possible alternatives should be evaluated and the choice that identifies the minimum cost makes for the final decision.

Make

It requires appropriate production equipment, suitable personnel, material, adequate space, supervision, design standards and involves overheads, maintenance, taxes, insurances, management attention and other indirect and hidden costs.

It provides work for idle equipment and personnel utilise scrap material, shorten delivery period, permits strict adherence to the raw material specification and quality of final product. It ensures continuity of supply, may cost less than purchase and keep design and research infor­mation secret.

Buy

Permits lower investment in facilities, smaller labour force, less handling, lower plant cost for building and upkeep, less overhead or taxes, insurance and supervision and less prob­lems of man-management relations.

Buy permits specialisation, allows manufacture by most efficient equipment, lowers inven­tories, change of design without loss of investment in equipment or inventory, obtaining best price of product, and supplying more varied experience and encourages growth of ancillaries.

Whether to make or buy is sometimes referred as a purchasing function, though the deci­sion whether to make components in one’s own factory or to buy them from market is a top management policy matter.

Theoretically, a company has choice of three alternatives before starting for a new product:

• Purchase the product complete from a contracted manufacturer.
• Purchase some components and materials, and manufacture and assemble the bal­ance in its own plants.
• Manufacture the product completely, starting with the extraction of basic raw materials.

In practice, almost no company considers the third alternative. Some companies choose the first alternative and obtain a new product completely from another company. These companies usually have no manufacturing units, but sell the product under their trade marks.

But in general, most of the companies make certain components of a product and buy oth­ers. The companies may buy a component from outside in semi-finished or complete state or buy the raw material only.

Factors for Make or Buy Decision

Factors Considered for Buying

• What quantities are involved?
• Will drawings need modification?
• Whether jigs, tools, gauges are loaned?
• Will demand be temporary or permanent?
• Will demand fluctuate?
• Are special manufacturing techniques involved?
• Is there any question of secrecy?
• Is there a likely market elsewhere?
• Are frequent design changes likely?
• Arrangement for inspection, sampling etc.
• Retention of own production personnel.
• What notice of termination is required?

Factors Considered for Making

• Are patents or copy rights involved?
• If so, what are the royalties?
• Have the best prices been obtained?
• Are the quantities optimized?
• Is the previously contracted firm already making something similar which could be added to the new item, thus reducing production cost?
• Techniques of production may be special.
• Is raw material readily available?
• If free material to be provided?
• Will any tax be involved?

Criteria for Make or Buy Decision

Companies prefer own manufacturing and buying only raw material or semi-finished parts. Such decision is made in the following cases:

• Finished product can be made cheaply by the firm than that by the outside suppliers.
• Finished product only is manufactured by limited number of outside firms, which are unable to meet the demand.
• The part has an importance for the firm, and requires extremely close quality control.
• The part can readily be manufactured with the firm’s existing facilities and the part is similar to other items in which the company has manufacturing experience.
• Requires high investment on facilities, which are not available at supplier’s plant.
• Has a demand that is both stable and relatively large.

Companies will usually buy a finished part from an outside supplier when:

• They do not have facilities to make it and there are other profitable opportunities for investing company capital.
• Existing facilities can be used more economically to make other parts.
• The skill of personnel employed by company is not readily available to manufacture the part.
• Patent or other legal barriers prevent the company for making the part.
• Demand for the part is either temporary or seasonal.

Factory Gate Pricing

This is sometimes also referred to as purchasing on an ‘ex works’ basis. The cost of transporting the goods to the buyer’s facilities may hide some extra cost that the buying company could avoid. Oft en companies show a remarkable lack of interest in this area, preferring to see it as somebody else’s problem. The reality is that some costs could be eliminated and a higher level of control over the inbound supplies may be achieved.

If raw materials are being sourced from a variety of locations, whether it is on a national, continental or global scale, then there may be a possibility of removing some of the associated transport costs by employing a third party to co-ordinate this process. Large freight-forwarding companies may be able to pool one company’s transport requirements with others so that a better price is obtained.

Another way of removing cost from the inbound side of a business is to use the vehicles delivering finished goods to collect from suppliers. This will allow a company to buy raw materials at ex-works prices and utilize its delivery fleet more effectively as well. It may be possible to have the same organization that handles final deliveries co-ordinating inbound raw material transport needs as well.

Simple Cost Analysis

A make or buy cost analysis involves a determination and comparison of the cost to make the part and the cost to buy it. The final make or buy decision must be based on a careful weighing of the cost considerations and various quantitative considerations.

The most difficult make-buy factors to assess are those that will significantly be affected by change in economic conditions, technological advancement, growth of the firm, or changes in the labour manage­ment relations in the future. Studies show that more mistakes are made in making what could be more profitable to bought than in buying what could more profitable to be made.