Make-or-Buy Decisions (Encyclopedia of Management)
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 partr significantly modified a product or parts 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.
The increased existence of firms that utilize the concept of lean manufacturing has prompted an increase in outsourcing. Manufacturers are tending to purchase subassemblies rather than piece parts, and are outsourcing activities ranging from logistics to administrative services. In their 2003 book World Class Supply Management, David Burt, Donald Dobler, and Stephen Starling present a rule of thumb for out-sourcing. It prescribes that a firm outsource all items that do not fit one of the following three categories: (1) the item is critical to the success of the product, including customer perception of important product attributes; (2) the item requires specialized design and manufacturing skills or equipment, and the number of capable and reliable suppliers is extremely limited; and (3) the item fits well within the firm's core competencies, or within those the firm must develop to fulfill future plans. Items that fit under one of these three categories are considered strategic in nature and should be produced internally if at all possible.
Make-or-buy decisions also occur at the operational level. Analysis in separate texts by Burt, Dobler, and Starling, as well as Joel Wisner, G. Keong Leong, and Keah-Choon Tan, suggest these considerations that favor making a part in-house:
- Cost considerations (less expensive to make the part)
- Desire to integrate plant operations
- Productive use of excess plant capacity to help absorb fixed overhead (using existing idle capacity)
- Need to exert direct control over production and/or quality
- Better quality control
- Design secrecy is required to protect proprietary technology
- Unreliable suppliers
- No competent suppliers
- Desire to maintain a stable workforce (in periods of declining sales)
- Quantity too small to interest a supplier
- Control of lead time, transportation, and warehousing costs
- Greater assurance of continual supply
- Provision of a second source
- Political, social or environmental reasons (union pressure)
- Emotion (e.g., pride)
Factors that may influence firms to buy a part externally include:
- Lack of expertise
- Suppliers' research and specialized know-how exceeds that of the buyer
- cost considerations (less expensive to buy the item)
- Small-volume requirements
- Limited production facilities or insufficient capacity
- Desire to maintain a multiple-source policy
- Indirect managerial control considerations
- Procurement and inventory considerations
- Brand preference
- Item not essential to the firm's strategy
The two most important factors to consider in a make-or-buy decision are cost and the availability of production capacity. Burt, Dobler, and Starling warn that "no other factor is subject to more varied interpretation and to greater misunderstanding" Cost considerations should include all relevant costs and be long-term in nature. Obviously, the buying firm will compare production and purchase costs. Burt, Dobler, and Starling provide the major elements included in this comparison. Elements of the "make" analysis include:
- Incremental inventory-carrying costs
- Direct labor costs
- Incremental factory overhead costs
- Delivered purchased material costs
- Incremental managerial costs
- Any follow-on costs stemming from quality and related problems
- Incremental purchasing costs
- Incremental capital costs
Cost considerations for the "buy" analysis include:
- Purchase price of the part
- Transportation costs
- Receiving and inspection costs
- Incremental purchasing costs
- Any follow-on costs related to quality or service
One will note that six of the costs to consider are incremental. By definition, incremental costs would not be incurred if the part were purchased from an outside source. If a firm does not currently have the capacity to make the part, incremental costs will include variable costs plus the full portion of fixed overhead allocable to the part's manufacture. If the firm has excess capacity that can be used to produce the part in question, only the variable overhead caused by production of the parts are considered incremental. That is, fixed costs, under conditions of sufficient idle capacity, are not incremental and should not be considered as part of the cost to make the part.
While cost is seldom the only criterion used in a make-or-buy decision, simple break-even analysis can be an effective way to quickly surmise the cost implications within a decision. Suppose that a firm can purchase equipment for in-house use for $250,000 and produce the needed parts for $10 each. Alternatively, a supplier could produce and ship the part for $15 each. Ignoring the cost of negotiating a contract with the supplier, the simple break-even point could easily be computed:
$250,000 + $10Q = $15Q
$250,000 = $15Q $10Q
$250,000 = $5Q
50,000 = Q
Therefore, it would be more cost effective for a firm to buy the part if demand is less than 50,000 units, and make the part if demand exceeds 50,000 units. However, if the firm had enough idle capacity to produce the parts, the fixed cost of $250,000 would not be incurred (meaning it is not an incremental cost), making the prospect of making the part too cost efficient to ignore.
Stanley Gardiner and John Blackstone's 1991 paper in the International Journal of Purchasing and Materials Management presented the contribution-per-constraint-minute (CPCM) method of make-or-buy analysis, which makes the decision based on the theory of constraints. They also used this approach to determine the maximum permissible component price (MPCP) that a buyer should pay when outsourcing. In 2005 Jaydeep Balakrishnan and Chun Hung Cheng noted that Gardiner and Blackstone's method did not guarantee a best solution for a complicated make-or-buy problem. Therefore, they offer an updated, enhanced approach using spreadsheets with built-in liner programming (LP) capability to provide "what if" analyses to encourage efforts toward finding an optimal solution.
Firms have started to realize the importance of the make-or-buy decision to overall manufacturing strategy and the implication it can have for employment levels, asset levels, and core competencies. In response to this, some firms have adopted total cost of ownership (TCO) procedures for incorporating non-price considerations into the make-or-buy decision.
Balakrishnan, Jaydeep, and Chun Hung Cheng. "The Theory of Constraints and the Make-or-Buy Decision: An Update and Review." Journal of Supply Chain Management: A Global Review of Purchasing & Supply 41, no. 1 (2005): 407.
Burt, David N., Donald W. Dobler, and Stephen L. Starling. World Class Supply Management: The Key to Supply Chain Management. 7th ed. Boston: McGraw-Hill/Irwin, 2003.
Gardiner, Stanley C., and John H. Blackstone, Jr. "The 'Theory of Constraints' and the Make-or-Buy Decision." International Journal of Purchasing & Materials Management 27, no. 3 (1991): 383.
Wisner, Joel D., G. Keong Leong, and Keah-Choon Tan. Principles of Supply Chain Management: A Balanced Approach. Mason, OH: Thomson South-Western, 2005.