Value analysis is one of the major techniques of cost reduction and cost prevention. It is a disciplined approach that ensures necessary functions for minimum cost without sacrificing quality, reliability, performance, and appearance. According to the Society of American Value Engineers (SAVE),
Value Analysis is the systematic application of recognized techniques which identify the function of a product or service, establish a monetary value for the function and provide the necessary function reliably at the lowest overall cost.
It is an organized approach to identify unnecessary costs associated with any product, material part, component, system or service by analysing the function and eliminating such costs without impairing the quality, functional reliability, or the capacity of the product to give service
1 WHEN TO APPLY VALUE ANALYSIS
One can definitely expect very good results by initiating a VA programme if one or more of the following symptoms are present:
1. Company’s products show decline in sales.
2. Company’s prices are higher than those of its competitors.
3. Raw materials cost has grown disproportionate to the volume of production.
4. New designs are being introduced.
5. The cost of manufacture is rising disproportionate to the
volume of production.
6. Rate of return on investment has a falling trend.
7. Inability of the firm to meet its delivery commitments.
The term ‘value’ is used in different ways and, consequently, has different meanings. The designer equates the value with reliability; a purchase person with price paid for the item; a production person with what it costs to manufacture, and a sales person with what the customer is willing to pay.
Cost value. It is the summation of the labour, material, overhead and all other elements of cost required to produce an item or provide a service compared to a base.
Exchange value. It is the measure of all the properties, qualities and features of the product, which make the product possible of being traded for another product or for money.
Value analysis/value engineering
It is a special type of cost reduction technique. It critically investigates and analyses the different aspects of materials, design, cost and production of each and every component of the product in produce it economically without decreasing its utility, function or reliability.
The various application areas of value engineering are machine tool industries, industries making accessories for machine tools, auto industries, import substitutes, etc.
In the process of carrying out business activities of an organization, a component/product can be made within the organization or bought from a subcontractor. Each decision involves its own costs.
So, in a given situation, the organization should evaluate each of the above make or buy alternatives and then select the alternative which results in the lowest cost. This is an important decision since it affects the productivity of the organization
In the long run, the make or buy decision is not static. The make option of a component/product may be economical today; but after some time, it may turn out to be uneconomical to make the same.
Thus, the make or buy decision should be reviewed periodically, say, every 1 to 3 years. This is mainly to cope with the changes in the level of competition and various other environmental factors.
Make or Buy Decisions - is a determination whether to produce a component part internally or to buy it from an outside supplier. The Organization should evaluate the costs and benefits of manufacturing a product or product component against purchasing it and then select the alternative which results in the lower cost.
1 CRITERIA FOR MAKE OR BUY
In this section the criteria for make or buy are discussed.
1. Criteria for make
The following are the criteria for make:
1.The finished product can be made cheaper by the firm than by outside suppliers.
2. The finished product is being manufactured only by a limited number of outside firms which are unable to meet the demand.
3. The part has an importance for the firm and requires extremely close quality control.
4. The part can be manufactured with the firm’s existing facilities and similar to other items in which the company has manufacturing experience.
2. Criteria for buy
The following are the criteria for buy:
1. Requires high investments on facilities which are already available at suppliers plant.
2. The company does not have facilities to make it and there are more profitable opportunities for investing company’s capital.
3. Existing facilities of the company can be used more economically to make other parts.
4. The skill of personnel employed by the company is not readily adaptable to make the part.
5. Patent or other legal barriers prevent the company for making the part.
6. Demand for the part is either temporary or seasonal.
APPROACHES FOR MAKE OR BUY DECISION
Types of analysis followed in make or buy decision are as follows:
1. Simple cost analysis
2. Economic analysis
3. Break-even analysis
1. Simple Cost Analysis
The concept is illustrated using an example problem.
A company has extra capacity that can be used to produce a sophisticated fixture which it has been buying for Rs. 900 each. If the company makes the fixtures, it will incur materials cost of Rs. 300 per unit, labour costs of Rs. 250 per unit, and variable overhead costs of Rs. 100 per unit. The annual fixed cost associated with the unused capacity is Rs. 10,00,000. Demand over the next year is estimated at 5,000 units. Would it be profitable for the company to make the fixtures?
We assume that the unused capacity has alternative use.
Cost to make
Variable cost/unit = Material + labour + overheads
= Rs. 300 + Rs. 250 + Rs. 1 0 0
= Rs. 650
Total variable cost = (5,000 units) (Rs. 650/unit)
= Rs. 32,50,000
Add fixed cost associated
with unused capacity + Rs. 10,00,000
Total cost = Rs. 42,50,000
Cost to buy
Purchase cost = (5,000 units) (Rs. 900/unit)
Add fixed cost associated = Rs. 45,00,000
with unused capacity + Rs. 10,00,000
Total cost = Rs. 55,00,000
The cost of making fixtures is less than the cost of buying fixtures from outside. Therefore, the organization should make the fixtures.
2. Economic Analysis
The following inventory models are considered to illustrate this concept:
The formulae for EOQ and total cost (TC) for each model are given in the following table:
D = demand/year
P = purchase price/unit
Cc = carrying cost/unit/year
Co = ordering cost/order or set-up cost/set-up
k = production rate (No. of units/year)
r = demand/year
Q1 = economic order size
Q2 = economic production size
TC = total cost per year
An item has a yearly demand of 2,000 units. The different costs in respect of make and buy are as follows. Determine the best option.
Item cost/unit Rs. 8.00 Rs. 5.00
Procurement cost/order Rs. 120.00
Set-up cost/set-up Rs. 60.00
Annual carrying cost/
item/year Rs. 1.60 Rs. 1.00
Production rate/year 8,000 units
D = 2,000 units/year
Co = Rs. 120/order
Cc = Rs. 1.60/unit/year
Co = Rs. 60/set-up
r = 2,000 units/year
Cc = Re 1/unit/year
k = 8,000 units/year
= Rs. 10,424.26
Result: The cost of making is less than the cost of buying.
Therefore, the firm should go in for the making option.
3. Break-even Analysis
The break-even analysis chart is shown in Fig
TC = total cost FC = fixed cost
TC = FC + variable cost
B = the intersection of TC and sales (no loss or no gain situation)
A = break-even sales
= break-even quantity/break-even point (BEP)
The formula for the break-even point (BEP) is
BEP = FC / Selling price / unit − Variable cost / unit
There are three alternatives available to meet the demand of a
particular product. They are as follows:
(a) Manufacturing the product by using process
A (b) Manufacturing the product by using
process B (c) Buying the product
The details are as given in the following table:
Cost elements Manufacturing ManufacturingBuy
the product by the product by
process A process B
Fixed cost/year (Rs.) 5,00,000 6,00,000
Variable/unit (Rs.) 175 150
Purchase price/unit (Rs.) 125
The annual demand of the product is 8,000 units. Should the company make the
product using process A or process B or buy it?
Annual cost of process A = FC + VC Volume
= 5,00,000 + 175 8,000
= Rs. 19,00,000
Annual cost of process B = FC + VC Volume
= 6,00,000 + 150 8,000
= Rs. 18,00,000
Annual cost of buy = Purchase price/unit Volume
= 125 8,000
= Rs. 10,00,000
Since the annual cost of buy option is the minimum among all the alternatives, the company should buy the product .