The Make Vs Buy Decision Process

In todays competitive world, it is imperative that each and every organization maximize its profits and minimize its costs. It is important to be efficient, cost effective and to provide quality of the highest order. Therefore, each and every organization competing for market share ends up with a dilemma: Should they produce the product themselves by making huge investments at a considerable level of risk or outsource it to a 3rd party manufacturer to keep costs low with lesser liability? As the business world progressed from the sixties and seventies, where vertical integration was the norm, today outsourcing has become a strategic advantage of an organization competing in world markets. It provides them with diversity, technical advantages and expertise and minimum level of costs and liabilities. But it also loses out on asset value, expansion opportunities, quality control and supplier unreliability, which make production a better venture than outsourcing. This white paper deals with understanding the factors that go into a make-or-buy decision. Also it will aim to look at the make-or-buy decision from a futuristic point of view, whether these reasons will still hold good in the future.

INTRODUCTION

The question arises “Why do some firms prefer a vertically integrated structure, while others choose to specialize in one stage of production and outsource the remaining stages to other firms? In other words, is it better for a firm to make its own inputs or buy them on the spot from the supplies market or maintain a strategic relationship with a particular supplier? Traditionally, economists viewed vertical integration or vertical control as a means to monopolize an industry through gain of input markets and distribution channels. By contrast, the transaction cost approach, emphasized that vertical coordination can be an effective and efficient means of protecting relationship specific investments or mitigating potential conflicts due to incomplete contracting. As transaction cost economics was developed in the seventies and eighties, research began to explain the “Make versus Buy decision” using transactional cost reasoning.

Coase (1937) was one of the first to explain that boundaries of a firm depended on the cost of transactions also, and not just the productive technology. In the Coasian framework, the decision to organize transactions within the firm as opposed to on the open market-the “make or buy decision”-depends on the relative costs of internal versus external exchange. The market mechanism for “Buy” decision entails costs: discovering the relevant prices and finding the lowest and most suitable, negotiating and enforcing contracts, and so on. By following the “Make” decision by producing within the firm, the entrepreneur may be able to reduce these “transaction costs” by coordinating these activities himself. However, internal organization brings other kinds of transaction costs, namely problems of information flow, incentives, monitoring, and performance evaluation. The boundary of the firm to go for a “Make or Buy” decision is then, determined by the trade off, at the margin, between the relative transaction costs of external and internal exchange. In this sense, firm boundaries depend not only on technology, but also on organizational considerations; that is, on the costs and benefits of various contracting alternatives.

Today’s managers consider the “Make or Buy” decision as a significant part of their business strategy. The “Make versus Buy” strategy can be a major determinant of profitability and can make a major contribution of to the financial health of the firm (Yoon and Nadimathu, 1994). Till date, buying or outsourcing has been done by firms on the basis of best available price, not considering factors like quality and delivery. However, multiple significant factors like delivery, quality, reliability, technical capability, cost capability and financial health of the organization have to be taken into account before going in for such a decision.

THE MAKE VERSUS BUY DECISION

Most organizations take into account of strategic implications while pondering over such a decision. Many organizations prefer to buy, looking at short term implications like cost reduction (Ford et al., 1993). In addition to this, many firms find themselves with an initial position that has been inherited from the past and their position in the supply chain has already been established with the extent of vertical and horizontal integration already mapped out. However, these are short term implications with no regard to long term consequences.

History

The conceptual basis for a “Make versus Buy” decision is Williamson’s theory of cost analysis given in 1975. Transaction cost analysis combines economic and management theory to determine the best possible relationship a firm can have with a marketplace. This led to the foundations of purchasing discipline, which analyses factors to determine the internal and external boundaries of a firm. Williamson used the term “Asset Specificity” to define the investment in transaction specific assets. When asset specificity and uncertainty are low and the transactions really frequent, then transactions will be governed by markets. When asset specificity was higher along with transactional difficulties, it led to transactions being held internally with focus on vertical integration. Medium levels of both led to the formation of co operative alliances between organizations. Partnering arrangements recognize the opportunity of working together for virtual benefits in the long term. Many firms actively seek partnership with supplier firms to reduce the risks associated with outsourcing. During the 1980’s and 1990’s, many firms found vertical integration to be inflexible in the rapidly changing business environment. For example, GM, with a high level of vertical integration, suffered from high costs due to its union workers earning twice as much as non unionized workers working with suppliers (Walters, 1996). However many companies and firms face problems pursuing such strategies.

Problems encountered in a “Make versus Buy” situation

Some of the important problems companies face in a “Make versus Buy” decision is:

Because there isn’t a formal way to evaluate a decision: Many companies make decisions based on overhead costs, rather than business sense. Many factors are neglected, such as:

Should a company maintain its competence by making in house or outsource?

Whether the manufacturing technologies lag behind competitors?

Does outsourcing have any effect on perceived quality?

Investments required to match capabilities of supplier?

Whether the accounting systems are correct- Decision is mostly based on cost issues. It is important to understand whether accounting systems are keeping track of the various technological changes. Eg. Direct labor hours for allocating overhead, when process is highly automated.

Competitive implications of the decision: most firms do not analyze the differences in core competencies to understand the decision making process. Many firms do not analyze the impact of sourcing decisions, especially while considering flexibility, reliability and customer service etc.

The “Make or Buy” decision is highly complex and one of the most difficult tasks faced by firms. It requires excellent judgment to assess the underlying tradeoffs as well as a balance to the short as well as long term goals of the firm. Also, considering the changing competitive environment of the business world, a decision that may have been appropriate in the past may have to be resolved in a totally different manner today or in the future.

Factors affecting the Make versus Buy decision

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Decisions regarding Make and Buy are one of the most strategic decisions made by management. They address the basic organizational choice of functions/ products that need to be developed internally and/or purchased. The Make versus Buy decisions are usually the major determinants of profitability and are significant to the financial health of any organization.

The many drivers affecting the “Make versus Buy” decisions are:

Cost

Cost of in-house production or buying

Return on Investment

Profitability and margins involved

Capacity

Level of utilization and economies of Scale.

Strategic implications: like Quality, technical advantages and protecting the assets involved.

THE MAKE DECISION: IN-HOUSE MANUFACTURING

The make decision pertains to manufacturing internally. This is driven by strategic plans of the firm, with respect to their plans for growth in the future. In house manufacturing can be preferred when there is high emphasis on quality and delivery. By manufacturing in house and not relying on an external supplier, a firm can protect its reputation by delivering the quality it wants in the time it desires. Also, a firm can choose the make decision on the basis of intellectual property. Intellectual property refers to innovations, designs and inventions that have been created to give a firm a competitive advantage. Even though it is common for companies to get outsourced manufacturers to sign confidentiality agreements to not steal or duplicate any technology, each country has its own legal ramifications in regard to intellectual property. Outsourcing the manufacturing allows others to see the technology behind the product and hence, increases the risk of the technology being duplicated. In these cases, it is better for a company to manufacture within, even at a higher cost, to maintain its competitive advantage through innovation.

Advantages of In House Manufacturing

A company or firm can choose to manufacture in house by looking at the following conditions:

The lowered production costs due to achieving economies of scale.

Assured supply in case of unreliable suppliers

By concentrating on manufacturing, better quality control possibilities

Maintain talent within the organization as well as protect proprietary technology.

Better valuation of company by increased size and

To help remove supplier collusion, cartelization

To improve upon integration possibilities.

Reasons for In House Manufacturing

PRO’s & CON’s of In-House Manufacturing

PRO

CON

Achieve direct process control

Lesser available support

Protect proprietary technologies

Higher fixed costs leading to lowered margins

Better customization flexibilities

Higher level of risk

Lowered costs

Higher capital investments

Easier planning process

Specialist knowledge required

Shorter communication routes

Tying up resources and personnel

The figure below illustrates the decision looking at staff capabilities and product differentiation. If costs are not bought into the equation, a Make decision only makes sense when staff capabilities are known and the product is differentiated well enough to be profitable in the long term.

Figure: Make or Buy on the basis of product differentiation and staff capabilities

THE BUY DECISION: BUYING/SOURCING

The Buy decision deals with outsourcing the manufacturing process to other companies. This decision is generally made bearing costs in mind. Companies outsourcing components of their manufacturing processes often do so to areas to obtain skilled labor at significantly lower wages than possible in their own locations. Many countries offer construction and tax incentives for relocation of operations and sometimes have relaxed standards towards regulations like environmental and accounting. The cheaper labor allows the firm to control its expenses and also dedicate its core workforce to strategic business operations rather than the outsourced ones. It allows for lesser investment, thereby lowering the risks associated with it. It can also save on lowered operational costs and lower workforce requirements. If a product is not a core business, it makes sense to let someone with the technology and expertise to manufacture rather than taking the effort of creating a facility to develop it on your own, especially if the product has little or no strategic implications.

Advantages of Buying/Outsourcing

A company or firm can choose to outsource by looking at the following conditions:

The reduced investment in assets and redirection of resources towards more critical projects.

Lowered operational expenditures and requirements

Savings through lesser inventory and warehousing costs. In some cases, outsourcing can help save on shipping costs too.

Mitigation of risk because of reduced liabilities.

Due to lesser competence to manufacture or because the product has little or no strategic value associated with it.

Availability of external support and technology with the outsourced manufacturer.

Due to limited production capabilities/ facilities or requirements.

Reasons for Buying/Sourcing

PRO’s & CON’s of Buying/Sourcing

PRO

CON

Lowered capital investment

No direct process control

Mitigated risk

Reliability and quality issues

Lowered operational costs

More dependency on supplier

Availability of external support

Lead time fluctuations

Savings on wages, inventory and warehousing

Efficient information flow is prerequisite

Allows more focus on core, strategic parts of business

Higher employee turnover

The Buy decision is best when a product does not play a role in the company’s vision or strategy. Buying is best when standard business operation procedures are required. As illustrated with the figure below, it is best to buy when there is importance of the product or if the competency in the firm to make the product is little or none. In this sense, it makes better business sense to buy as the suppliers are more experienced and knowledgeable. When the importance is low, it becomes better to partner with a supplier as it can be seen as an opportunity for a firm to increase its level of competence at little or no risk.

Figure: Make or Buy on the basis of product importance and firm’s competence

COST BENEFIT ANALYSIS OF “MAKE VERSUS BUY” DECISION

In today’s competitive world, the decision of make versus buy is done by taking a deeper look into the individual cost benefit analysis of each situation. The concept is simple enough, the lower the costs, the more profitable the firm will be. Cost benefit analysis is done by looking at costs of:

Volume – Depending on the requirement volume, costs are calculated by looking at labor, material and overhead costs of manufacturing in house and cost of products and transportation for outsourced products. Generally, for small volumes it does not make business sense to manufacture and it is more convenient to outsource to save on costs and resources.

Fixed costs – If the fixed costs are high for assets such as facilities, equipment etc. it is better to outsource to remove fixed and overhead costs.

Per unit cost of making – also has to be accounted for in this decision. If a large volume is required, then considering fixed and variable costs, the per unit cost of manufacturing may be lowered by achieving economies of scale, thus making it better to go for the make option rather than buy or outsource.

Per unit cost of acquiring goods from supplier – If the per unit cost of supplier market is lower than the cost of manufacturing, it is better to outsource the operational activities as the supplier could be taking advantages of economies of scale or may have access to technologies that the firm doesn’t.

General Equation

Cost to Buy = Volume * Per-unit Cost of getting from supplier

Cost to Make = Fixed Costs + (Volume * Per-unit cost of making)

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From the graph, it can be deciphered that at lower volume levels, the cost to buy is significantly lower than the cost to make, primarily because of no fixed costs and supplier’s advantage of economies of scale. But as the volume increases, the economies of scale comes in thus allowing the total cost per unit of manufacturing to go below the cost of buying. Therefore depending on volume, cost benefit analysis should be done to find the lower cost option, especially if there is little or no proprietary technology or strategic implications involved. Also it is imperative for a firm to check cost benefit analysis of non core functions in the organizations to see what can be outsourced to save on resources and costs.

Costs benefit Example

Case 1

To purchase a component costs $48/unit. The manufacturer doesn’t own machinery to manufacture this. Cost of machinery is $40,000. The depreciation period is 5 years after which the value is nil. Interest rate is 4% per year. To produce the component, a machine takes 2 hours and works for 1000 hours in a year and is combined to operate with another machine. The adjustment as well as uploading and unloading of materials requires some operations. The time for these operations are estimated at 100 hours per year and its costs $40 per hour. Cost of materials amounts to $10 per unit. Maintenance and replacement costs are nil for the first year, $1000 the second, $2000 the third, $3000 the fourth and $4000 the fifth year. A total of 500 components are required per year.

Component cost if purchased: 500*$48 = $24,000

If manufactured in house (average price per unit/year)

Depreciation costs: 40000/5 = $8,000

Interest: 4% of 40000/2(linear installments) = $800

Materials: 500*10 $5,000

Labor costs: 100 hours* 40 $4,000

Additional costs: (0+1000+2000+3000+4000)/5 $2,000

TOTAL (for 500 components) $19,800

It is clear that it is better to manufacture rather than source, with a savings of (24,000 – 19,800) =$4200

Case 2

With all other components remaining the same, if the cost of machinery is higher, say $70,000 then in this case,

If manufactured in house (average price per unit/year)

Depreciation costs: 70000/5 = $14000

Interest: 4% of 70000/2(linear installments) = $1400

Materials: 500*10 $5,000

Labor costs: 100 hours* 40 $4,000

Additional costs: (0+1000+2000+3000+4000)/5 $2,000

TOTAL (for 500 components) $26,400

It is clear that it is better to source in this case, with a savings of (26,000 – 24,000) =$2000

STRATEGIC IMPLICATIONS OF “MAKE VERSUS BUY” DECISION

The “Make versus Buy” decision is also decided by looking at the strategic implications and core competencies of the firm. If a firm has long term plans to expand into new markets for which it requires the manufacturing know how, it would be better if the firm started investing and expanding itself towards in house manufacturing rather than outsourcing. But if the product doesn’t have any role in the long term planning process, it is better to outsource the product. Some firms continue to produce within even at higher costs to protect proprietary technology like patents which gives them a strategic, competitive advantage in the markets (eg. Pharmaceuticals). Outsourcing such processes will require the sharing of technology, thus making it susceptible to duplication and theft.

An analysis of the strategic impact along with competency shows that in house manufacturing is best when the strategic impact is high and it lies under the core competency of the firm. If a project is neither, it is better to source rather than make to lower liabilities and risks. If either strategy or competency is an issue, the decision has to be made looking into the future outlook of the firm and whether current product has the potential to be a competence later with strategic advantages.

SWOT ANALYSIS

CONCLUSION

A decision to make or buy can be made by looking critically at the factors listed below

MAKE IF

BUY IF

Skill set is available

Lack of in house expertise

Less expensive to make

Less expensive to buy

Availability of excess capacity

Insufficient capacity

Require direct control of processes

If confident of vendor capabilities

Solution is core to business

Solution is not core to business

Better quality control with in house manufacture

If confident of vendor delivering top quality

Business is unique and no off shelf solutions with customization present

Business is not unique and off shelf solutions allows for customization to your needs

Key Learning’s

The Make versus buy decision is situational in nature. It depends on a variety of factors other than just capital and profitability.

There are a variety of factors that can tip the balance for a make/buy decision:

Level of Risk/ Cost Benefits

Intensity of Local Competition & Extent of Market dominance

Strategic Outlook/ Core competencies involved

Monopoly/Dominance of Supplier

Extent & Effect of taxation

Future vision towards expansion and integration

Prevalence of Trade Barriers and tariffs

Extent of Professional management

Legal Issues and Complications

The success or failure of a Make Versus Buy Decision is dependent on how the organization has analyzed the above factors keeping in mind its vision for the future.

HYBRID MODELS & PLURAL SOURCING

Hybrid models consist of both make and buy functions as a part of organizational strategy. It may be due to lack of capacity to produce or to help mitigate risk and costs. It consists of both in and outsourcing coupled with other methods such as contracting and sub contracting. A strategic involvement between buyer and supplier allows for sharing of technologies and information, thus enabling greater levels of profitability. Suzuki is a suitable example because even though it manufactures engines for its cars, it also sources engines from Fiat to gain from the technical expertise Fiat owns.

Firms are more likely to make and buy rather than make or buy in the presence of complements between procurement modes and constraints on the use of individual modes. Hybrids are a mode of procurement that are different from either make or buy – they may not have complete ownership, but yet are characterized by a degree of cooperation and coordination. Hybrids are “mixed modes” of procurement in the sense that they display governance characteristics that appear to combine price and authority. However, plural sourcing refers to a different phenomenon- a mixing of modes in the sense that firms may simultaneously rely on pure hierarchy (internal procurement) as well as price (market contracts) for the same input. Thus, whereas hybrids refer to procurement of the entire volume from a single mode that exhibits mixed governance characteristics, plural sourcing refers to the splitting up of total volume being procured across multiple modes, each of which may be a pure governance mode.

Hybrids and plural sourcing are better than a single “make or buy” model due to:

Mitigated Risk factor – less liability compared to either make or buy.

Better process and quality control in hands of the organization.

Improved delivery and lead times as immediate demand can be satisfied through in house manufacturing while sourcing can help satisfy constant demands.

More palatable to stakeholders who do not wish to invest too much or carry the burden of risk.

Opens many paths into new markets which have the potential to be strategic advantages or core competencies.

Maintain internal expertise and gather external expertise to improve competence.

Can help resist and avoid chances of backward integration by customers.