In this article you will read about:
- The 7 factors of a Make or Buy Analysis
- Operational vs. strategic Make or Buy Decision
- Distinction Make or Buy vs outsourcing
- Example
The 7 factors of a Make or Buy Analysis
The two fundamental alternatives, in-house production (make) or third party sourcing (buy) must be weighted with regard to value generation and competitiveness. As a rule, this happens as the result of the performance of a Make or Buy analysis. The factors to be considered in the analysis and how operational Make or Buyer Decisions can be distinguished from strategic ones will be addressed in the following.
The performance of a Make or Buy Analysis includes the weighing of risks and the taking into account of various influential factors - in addition to the economics of scale analysis. In particular costs, quality, concrete goals, liquidity and image considerations all must be taken into account when performing a Make or Buy Analysis.
A short overview of the key factors:
- Objective
- Cost analysis
- Liquidity
- Image
- Quality assurance
- Time factor
- Suppliers
1. Objective:
A clear statement of the objectives of the Make or Buy Decision (cost advantages, focus on the core business, etc.) is a prerequisite for a Make or Buy Analysis.
2. Cost analysis:
The comparison of procurement and production costs is definitely one of the most important factors of a Make or Buy Analysis. Respective costing models depend in particular on the capacity utilisation of a company. If the company does not make full use of its capacities, it may make sense to produce parts that were previously produced by third party in house to boost cost effectiveness. On the other hand, production bottlenecks (despite maximum capacity utilisation the desired volumes cannot be produced) make third party procurement practical. Otherwise, losses in sales will have to be accepted.
3. Liquidity:
The liquidity of a company primarily decides whether in-house production would be feasible. Hence, the expansion of production usually goes hand in hand with high investment costs that require a respective level of cash flow.
4. Image:
Image considerations also play a role in a Make or Buy Decision. Consequently, the sale of own product can, for instance depend greatly on the quality image of the supplier . If buyers place great emphasis on the quality image of certain components, in house production (due to the lack of awareness of the manufactured parts) may adversely impact sales.
5. Quality assurance
If there is a reason to scrutinise third party procured products, in house production may make sense - at least the responsibility for the quality assurance results lies within your own company.
6. Time factor:
Whether third party procurement or in house production will yield the desired results is one of the key factors for a Make or Buy Decision;
7. Suppliers:
Ultimately, it depends on the search and assessment of suitable suppliers whether third party procurement can be implemented successfully.
Operational vs. strategic Make or Buy Decision
As part of a Make or Buy Analysis, two fundamental directions may be identified that are linked to different demands. A distinction between the operational and strategic Make or Buy Decision is made. Below you will find a differentiation between the two fundamental types of Make or Buy Decisions.
Characteristics:
An operational Make or Buy Decision targets primarily short term cost savings; while a strategically oriented Make or Buyer decision pursues the long term creation of competitive advantages. While prior to the 1980s operational Make or Buy Decisions prevailed, today, it is primarily strategic Make or Buy Decisions play a huge role. Strategic Make or Buyer Decisions tend to be more complex than operational ones.
Objectives:
The operational Make or Buy Decisions pursues short time goals and is mostly cost oriented. It depends largely on the current capacity utilisation. The strategic Make or Buy Decision, on the other hand, targets the long term outsourcing of production or the takeover of production and goes hand in hand with the core business.
Know-how:
Operational Make or Buy Decisions require very little long term competencies or sharing of know-how since they are only implemented for a limited time. Strategically oriented Make or Buy Decisions, to the contrary, are definitely dependent on a decision for in house production or third party procurement paid with know-how development or loss.
Reversibility:
Whole operational Make or Buy Decisions are reversible for the most part, strategic Make or Buyer decisions that have already been are very costly to correct. This is due to the fact that a strategic Make or Buy Decision usually goes hand in hand with a vast conversion of the corporate structure and production processes.
Distinction Make or Buy vs outsourcing
An outsourcing decision may also be considered a Make or Buy Decision. The principle goal of outsourcing is to share for cost savings and increased flexibility competencies as well as responsibilities for certain resources with third parties. As a rule, however, outsourcing comprises processes and services that were previously delivered by one's own company. One refers to a Make or Buy Decision if the question about inhouse products or third party procurement relates to products.
Example of a Make or Buy Analysis
Based on a fictitious example the question of third party procurement or inhouse manufacturing can be examined.
A company is about to decide whether it will manufacture a product or purchase it for resale. For this product, the forecast calls for 2,000 units in sales per annum. The purchase price would be EUR 400 per unit.
For inhouse production, a machine would have to be purchased for EUR 500,000. Costs for transportation and conversions totaling EUR 100,000 would also be incurred. The interest rate for an investment loan is 3 percent. The machine could be used for ten years and could ultimately be sold for EUR 50,000.
A pro rata share of EUR 10,000 in wages would have to be allocated for the operation of the machine. The costs for materials and other costs, such as electricity, come in at EUR 300 per unit.
Based on these figures, it is possible to perform a Make or Buy Analysis that is, however limited to the cost factor based on the available data. In addition to procurement costs of EUR 600,000, the costing write-offs in an amount of EUR 55,000 (600,000 minus 50,000 residual value) / 10 years as well as costing interest in the amount of EUR 9,750 (procurement costs plus residual book value) have to be taken into account.
Hence, the per unit costs for inhouse production are EUR 337.38 Euro:
- Material and production costs: EUR 300
- Wages: EUR 5 (10,000 / 2000 units per annum)
- Costing depreciation: EUR 27.50 (55,000 / 2000 each per annum)
- Costing interest: EUR 4.88 (9,750 / 2000 each per annum)
Hence, inhouse production would cost EUR 62.62 less per unit and is the better choice.
Conclusion: More than a cost effectiveness analysis
The conclusion is that a Make or Buy Decision depends on a large number of factors. A pure cost effectiveness analysis is therefore only a part of a Make or Buy Decision and cannot replace it. Moreover, it makes a large difference whether companies pursue a long term approach as part of their Make or Buy decision or just a short term operational approach.