Make or buy issues

The Strategic issues
“What kind of an organization do we want to be?” This issue is the first, and perhaps most critical, to be addressed. Pride or purely emotional reasoning plays a major part in many decisions. Pride in Self-sufficiency can become a dominant factor that can lead to many problems. While self sufficiency in some areas is desirable or even necessary, it is impossible for even a large firm to become entirely self-sufficient.

These decisions influence the firms manufacturing operation shape and capacity by determining;

  • What product to make
  • What investments to make in plant and equipment
  • The framework for short term tactical and component decisions.
  • Development of new products.

Tactical make or buy decisions
This deal with the issue of temporary imbalance in manufacturing capacity e.g. changes in demand may make it possible to make everything in house.

Component make or buy decisions
Made at the design stage, these decisions have to do with whether a particular component should be made in – house or is bought.

Two keys prerequisites are essential to a thorough and sound analysis of the cost considerations of a make-or-buy decision.

  • Cost must be segregated between fixed costs and variable or incremental ones. Such cost figures must include all relevant costs, both direct and indirect, near term and anticipated changes. Realistic estimates of in-house production costs must include expected rejection rates and spoilage. These estimates also should consider the likely effects of learning resulting from long production runs.
  • Accurate and realistic data must be available on the investment required to make or to buy an item. Frequently, the working capital required in the manufacture of an item can equal and even exceed the investment required for facilities and equipment. It is essential to consider both the facilities and the working capital components of an investment. Cost factor in make or buy decisions often require the application of marginal costing and break – even analysis

1.marginal costing
this is a principle whereby valuable costs are charged to cost units and the fixed costs attributable to the relevant period written off in full against the contributions for that period contribution = purchase price – vc per them

The major elements of the cost considerations are:

  • Materials and labour costs
  • Follow on costs stemming from quality related problem
  • Incremental inventory carry on costs
  • Incremental factory overhead costs
  • Incremental management costs
  • Incremental purchase costs
  • Incremental costs of capital
  1. Desire to integrate plant operations
  2. Reproductive use of excess plant capacity to help absorb fixed costs
  3. Need to exert direct control over production and /or quality.
  4. Design secrecy required
  5. Unreliable suppliers
  6. Desire to maintain a stable work force (in periods of low sales )
  7. Potential lead time reduction
  8. Exchange rate risk
  9. Greater purchasing power with bulk purchase of materials.

When there is a significant difference in quality between items produced internally and items purchased or when a specified quality cannot be purchased, then management must consider these quality considerations in the make-or-buy decision. One argument for making over buying is the so-called impossibility of finding a supplier capable or willing to manufacture the item to the desired specifications. But further investigation should be conducted before this argument can be accepted.

Why are these specifications so much more rigid than those of the rest of the industry? The Manufacturer should reexamine the specifications and make every effort to secure the cooperation of potential suppliers to ensure that the quality specifications are realistic and that no satisfactory product is available. Frequently, suppliers can suggest alternatives that are just as dependable if they know the intended purpose of the item.

On the other hand, the firm may desire a level of quality below that commercially available. Suppliers may be selling only a quality far above that which would fully satisfy the need in question and may, at the same time, have so satisfactory a volume at the higher level as to have no interest in a lower quality product. If this is the case, the user may be justified in manufacturing the item. Frequently, it is claimed that in-house production may better satisfy manufacturing’s quality requirements. The user of an item usually better understands the operational intricacies involved in the item’s use. With a make decision, a better degree of coordination will probably exist between those responsible for producing the item and those responsible for assembling it. Communications between the two groups are facilitated compared with the situation in which the item is furnished by an outside supplier. If the firm has a weak purchasing department, such assumptions may be true. But with a professional purchasing operation, the flow of information and coordination between purchaser and supplier should result in no more problems than between two production activities of the same firm.

Since quality must be controlled in either the purchased or manufactured items, a competent quality assurance staff and a TQM (total quality management) program must be employed. The purchase order may state that the purchaser’s quality assurance inspectors have access to the supplier’s manufacturing, inspection, and shipping departments. Thus, the purchaser can maintain significant control and still not incur the additional cost resulting from manufacturing the item.

One of the most frequent reasons for making over buying is that a requirement may be too small to interest suppliers. Small volume requirements of unique, nonstandard items may be difficult to purchase. The firm may feel that it is forced to make such items; however, it may be economically imprudent to do so. The costs of planning, tooling, setup, and purchase of required raw materials
may be exorbitant. It may be far more cost effective to purchase the required item in larger quantities or to identify a suitable substitute.

If a large quantity of an item is required on a repetitive basis, then the analysis described in the Cost section should be made. The company should have a high degree of confidence that its requirements for the item will continue to the point that it receives a satisfactory ROI before deciding to make such an item. Frequently a firm will follow a conscious policy of making an item at a level of production sufficient to meet its minimum requirements and purchase additional items as required. This policy builds a degree of stability into the firm’s production activities and provides accurate comparative cost data. Such a policy should be adopted only after investigating the willingness and ability of suppliers to fill such fluctuating demand.

Service often is defined simply as reliable delivery. In a broader sense, it includes a wide variety of intangible factors that lead to greater satisfaction on the part of the purchasing firm. This consideration must be judged fairly and the purchasing firm must not be given undue credit with respect to service simply for emotional reasons. Merely because the item is produced in-house is not proof that service will be superior to that of a supplier.

Assurance of supply is a primary service consideration. When the lack of an item causes serious problems, such as total production stoppage, and totally reliable suppliers are not available, the decision to make rather than buy may be justified. When a purchaser is faced with a monopolistic environment, the service accompanying the product is generally somewhat poorer than in a highly competitive market. Such a situation may induce the would-be purchaser to make the product. If an item is used as a subcomponent on a product the purchaser is selling and is causing the entire product to be unreliable, the resulting loss of goodwill and sales may be significant enough to justify a make decision, even though the cost analysis does not support such a decision.

Specialized Knowledge
Frequently, a supplier possesses specialized knowledge, abilities, and production know-how that would be very expensive to duplicate. Suppliers may have a large R&D budget leading to improved and/or less expensive products. The protection of innovation achieved by the supplier is a critical aspect of trust, that is, the buyer must not under any condition give this innovation to a supplier’s competitor or use the technology were it to make the item.

Design or Production Process Secrecy
Occasionally, a firm decides to manufacture a certain part because additional industrial security can be provided, especially when the item is a key part for which a patent would not provide adequate protection. This justification must be used with caution, however, as the firm can provide very little protection against design infringement after sale. In short, if a patent will not protect a certain part, then in-house manufacturing may not either. Frequently, a firm may have developed a unique or proprietary production process. Such circumstances may support a decision to make over buying.

Urgent Requirements
The firm usually can purchase a small quantity much more readily than were it to produce the item. If the requirement is urgent, such as to preclude stopping an assembly line, the payment of a higher price to buy the item is justified.

Labor Problems
The production of any new item may require labor skills that the company does not possess. The hiring, cross-training, and upgrading of personnel may be a troublesome and complex process, especially if a union is involved. The company may be entering a field in which it has no experience and no adequately trained personnel. Labor problems are easily shifted to someone else, namely, the supplier, through a decision to buy.

The presence of unions within the company also may be a significant factor. Unions often have clauses in their contract prohibiting the purchasing of items that can be manufactured within the plant. The history of labor problems in the supplier’s company also may influence the make-or-buy decision.

Plant Capacity
Obviously the more significant the item in question is relative to the company’s size, the greater the probability that the item will be purchased rather than produced in house. When the item would require a significant investment, the smaller company has no rational decision other than to buy. Generally the more mature company will try to integrate items currently purchased into its production more often than will a new company. The new company understandably concentrates on increasing output and has very little excess capital or plant capacity to divert to production of components. Quite the opposite is true for the more mature company. Such a firm tends to have extra facilities, capital, and personnel and, therefore, is in a better position to increase profit by producing what was formerly purchased. Excess plant capacity and the likely duration of the excess capacity should always be considered in the make-or buy decision as should additional expenses such as tooling, setup, and training.

Capital Equipment
Manufacturers sometimes find it necessary to make a needed item, simply because a suitable supplier does not exist. This is most frequently the case with highly specialized manufacturing equipment.

Use of Idle Resources
A make decision can prove profitable to a firm even when suitable supplies are available. In periods of1 recession or business slumps, a firm is faced with the problem of idle plant equipment, labor, and management. By making a product that it may have been buying, a firm can put its idle machinery to work, retain skilled employees, and spread its overhead costs over a larger volume of production.

Perhaps the biggest benefits obtained from a make decision during a slump are in the area of labor relations. Employee morale can be maintained and layoff penalty costs can be avoided by timely use of the make decision. Even in times of recession, most firms find it desirable to retain highly skilled production personnel. These personnel can be kept at work and a stable workforce maintained by a decision to make. The long-run benefits from good labor relations are obvious. Great caution must be taken when basing a make decision primarily on temporary idle resources. Make decisions tend to be permanent. A decision to make temporarily an item under such circumstances should be reviewed when demand increases.

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