Make-or-Buy Decision

MAKE-OR-BUY DECISION:

Definition:

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 of production capacity.

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

Make-or-Buy decision situation:

The make-or-buy decision is the act of making a strategic choice between producing an item internally or buying it externally. 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.

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 their2003 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:

            The item is critical to the success of the product, including customer perception of important product attributes

            The item requires specialized design and manufacturing skills or equipment, and the number of capable and reliable suppliers is extremely limited

            The item fits well within the firm's core competencies, or within those the firm must develop to fulfill future plans. Items that fit less than 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 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.

Situation of Make-or-Buy Decisions:

International businesses frequently face sourcing decisions, decisions about whether they should make or buy the component parts that go into their final product. Should the firm vertically integrate to manufacture its own component parts or should it outsource them, or buy them from independent suppliers? Make-or-buy decisions are important factors of many firms' manufacturing strategies.

In the automobile industry, for example, the typical car contains more than 10,000 components, so automobile firms constantly face make-or-buy decisions. Ford of Europe, for example, produces only about 45 percent of the value of the Fiesta in its own plants. The remaining 55 percent, mainly accounted for by component parts, come from independent suppliers. In the athletic shoe industry, the make-or-buy issue has been taken to an extreme with companies such as Nike and Reebok having no involvement in manufacturing; all production has been outsourced, primarily to manufacturers based in low-wage countries.

Make-or-buy decisions pose plenty of problems for purely domestic businesses but even more problems for international businesses. These decisions in the international arena are complicated by the volatility of countries' political economies, exchange rate movements, changes in relative factor costs, and the like. In this section, we examine the arguments for making components and for buying them, and we consider the trade - offs involved in these decisions. Then we discuss strategic alliances as an alternative to manufacturing component parts within the company.

THE ADVANTAGES OF MAKE:

The arguments that support making component parts in-house--vertical integration--are fourfold. Vertical integration may be associated with lower costs, facilitate investments in highly specialized assets, protect proprietary product technology, and facilitate the scheduling of adjacent processes.

Lower Costs

It may pay a firm to continue manufacturing a product or component part in-house if the firm is more efficient at that production activity than any other enterprise. Boeing, for example, recently undertook a very detailed review of its make-or-buy decisions with regard to commercial jet aircraft (for details see the accompanying Management Focus). It decided that although it would outsource the production of some component parts, it would keep the production of aircraft wings in-house.

Its rationale was that Boeing has a core competence in the production of wings, and it is more efficient at this activity than any other comparable enterprise in the world. Therefore, it makes little sense for Boeing to out-source this particular activity.

Facilitating Specialized Investments

We first encountered the concept of specialized assets in Chapter 6 when we looked at the economic theory of vertical foreign direct investment. A variation of that concept explains why firms might want to make their own components rather than buy them. The argument is that when one firm must invest in specialized assets to supply another, mutual dependency is created. In such circumstances, each party fears the other will abuse the relationship by seeking more favorable terms.

Proprietary Product Technology Protection

Proprietary product technology is technology unique to a firm. If it enables the firm to produce a product containing superior features, proprietary technology can give the firm a competitive advantage. The firm would not want this technology to fall into the hands of competitors. If the firm contracts out the manufacture of components containing proprietary technology, it runs the risk that those suppliers will expropriate the technology for their own use or that they will sell it to the firm's competitors. Thus, to maintain control over its technology, the firm might prefer to make such component parts in-house.

An example of a firm that has made such decisions is given in the accompanying Management Focus, which looks at make-or-buy decisions at Boeing. While Boeing has decided to outsource a number of important components that go toward the production of an aircraft, it has explicitly decided not to outsource the manufacture of wings and cockpits because it believes that doing so would give away key technology to potential competitors.

Improved Scheduling

The weakest argument for vertical integration is that production cost savings result from it because it makes planning, coordination, and scheduling of adjacent processes easier. This is particularly important in firms with just-in-time inventory systems (which we discuss later in the chapter). In the 1920s, for example, Ford profited from tight coordination and scheduling made possible by backward vertical integration into steel foundries, iron ore shipping, and mining. Deliveries at Ford's foundries on the Great Lakes were coordinated so well that ore was turned into engine blocks within 24 hours. This substantially reduced Ford's production costs by eliminating the need to hold excessive ore inventories.

THE ADVANTAGES OF BUY:

The advantages of buying component parts from independent suppliers are that it gives the firm greater flexibility, it can help drive down the firm's cost structure, and it may help the firm to capture orders from international customers.

Strategic Flexibility

The great advantage of buying component parts from independent suppliers is that the firm can maintain its flexibility, switching orders between suppliers as circumstances dictate. This is particularly important internationally, where changes in exchange rates and trade barriers can alter the attractiveness of supply sources. One year Hong Kong might be the lowest-cost source for a particular component, and the next year, Mexico may be.

Sourcing component parts from independent suppliers can also be advantageous when the optimal location for manufacturing a product is beset by political risks. Under such circumstances, foreign direct investment to establish a component manufacturing operation in that country would expose the firm to political risks. The firm can avoid many of these risks by buying from an independent supplier in that country, thereby maintaining the flexibility to switch sourcing to another country if a war, revolution, or other political change alters that country's attractiveness as a supply source.

However, maintaining strategic flexibility has its downside. If a supplier perceives the firm will change suppliers in response to changes in exchange rates, trade barriers, or general political circumstances, that supplier might not be willing to make specialized investments in plant and equipment that would ultimately benefit the firm.

Lower Costs

Although vertical integration is often undertaken to lower costs, it may have the opposite effect. When this is the case, outsourcing may lower the firm's cost structure. Vertical integration into the manufacture of component parts increases an organization's scope, and the resulting increase in organizational complexity can raise a firm's cost structure. There are three reasons for this.

First, the greater the number of subunits in an organization, the greater is the problems of coordinating and controlling those units. Coordinating and controlling subunits requires top management to process large amounts of information about subunit activities. The greater the number of subunits, the more information top management must process and the harder it is to do well.

Offsets

Another reason for outsourcing some manufacturing to independent suppliers based in other countries is that it may help the firm capture more orders from that country. As noted in the Management Focus on Boeing, the practice of offsets is common in the commercial aerospace industry. For example, before Air India places a large order with Boeing, the Indian government might ask Boeing to push some subcontracting work toward Indian manufacturers. This kind of quid pro quo is not unusual in international business, and it affects far more than just the aerospace industry. Representatives of the US government have repeatedly urged Japanese automobile companies to purchase more component parts from US suppliers in order to partially offset the large volume of automobile exports from Japan to the United States.

Trade-offs

Trade-offs is involved in make-or-buy decisions. The benefits of manufacturing components in-house seem to be greatest when highly specialized assets are involved, when vertical integration is necessary for protecting proprietary technology, or when the firm is simply more efficient than external suppliers at performing a particular activity.

When these conditions are not present, the risk of strategic inflexibility and organizational problems suggest that it may be better to contract out component part manufacturing to independent suppliers. Since issues of strategic flexibility and organizational control loom even larger for international businesses than purely domestic ones, an international business should be particularly wary of vertical integration into component part manufacture. In addition, some outsourcing in the form of offsets may help firm gain larger orders in the future.

Strategic Alliances with Suppliers

Several international businesses have tried to reap some of the benefits of vertical integration without the associated organizational problems by entering strategic alliances with essential suppliers. For example, in recent years we have seen an alliance between Kodak and Canon, under which Canon builds photocopiers for sale by Kodak, and an alliance between Apple and Sony, under which Sony builds laptop computers for Apple. By these alliances, Kodak and Apple have committed themselves to long-term relationships with these suppliers, which have encouraged the suppliers to undertake specialized investments.

Recall from our earlier discussion that a lack of trust inhibits suppliers from making specialized investments to supply a firm with inputs. Strategic alliances build trust between the firm and its suppliers. Trust is built when a firm makes a credible commitment to continue purchasing from a supplier on reasonable terms. For example, the firm may invest money in a supplier--perhaps by taking a minority shareholding--to signal its intention to build a productive, mutually beneficial long-term relationship.

This kind of arrangement between the firm and its parts suppliers was pioneered in Japan by large auto companies such as Toyota. Many Japanese automakers have cooperative relationships with their suppliers that go back for decades. In these relationships, the auto companies and their suppliers collaborate on ways to increase value - added by, for example, implementing just-in-time inventory systems or cooperating in the design of component parts to improve quality and reduce assembly costs. These relationships have been formalized when the auto firms acquired minority shareholdings in many of their essential suppliers to symbolize their desire for long-term cooperative relationships with them.

At the same time, the relationship between the firm and each essential supplier remains market mediated and terminable if the supplier fails to perform up to standard. By pursuing such a strategy, the Japanese automakers capture many of the benefits of vertical integration, particularly those arising from investments in specialized assets, without suffering the organizational problems that come with formal vertical integration. The parts suppliers also benefit from these relationships because since they grow with the firm they supply and they share in its success.

Because of these strategies, Toyota manufactures only 27 percent of its component parts in-house, compared to 48 percent at Ford and 67 percent at GM. Of these three firms, Toyota appears to spend the least on component parts, suggesting it has captured many of the benefits that induced Ford and GM to vertically integrate.¹⁹

In general, the trends toward just-in-time systems (JIT), computer-aided design (CAD), and computer-aided manufacturing (CAM) seem to have increased pressures for firms to establish long-term relationships with their suppliers. JIT, CAD, and CAM systems all rely on close links between firms and their suppliers supported by substantial specialized investment in equipment and information systems hardware. To get a supplier to agree to adopt such systems, a firm must make a credible commitment to an enduring relationship with the supplier--it must build trust with the supplier. It can do this within the framework of a strategic alliance.