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The make-or-buy decision is the act of making a strategic choice between produci

ng an item internally (in-house) or buying it externally (from an outside suppli


er). The buy side of the decision also is referred to as outsourcing. Make-or-bu
y decisions usually arise when a firm that has developed a product or partâ or sign
ificantly modified a product or partâ 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. Obviou
sly, 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 e
nvironment. Issues like government regulation, competing firms, and market trend
s all have a strategic impact on the make-or-buy decision. Of course, firms shou
ld 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 a
dvantage.
The increased existence of firms that utilize the concept of lean manufacturing
has prompted an increase in outsourcing. Manufacturers are tending to purchase s
ubassemblies rather than piece parts, and are outsourcing activities ranging fro
m logistics to administrative services. In their 2003 book World Class Supply Ma
nagement, David Burt, Donald Dobler, and Stephen Starling present a rule of thum
b for out-sourcing. It prescribes that a firm outsource all items that do not fi
t 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) t
he 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 ca
tegories 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 (usi
ng 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 an
d the availability of production capacity. Burt, Dobler, and Starling warn that
"no other factor is subject to more varied interpretation and to greater misunde
rstanding" Cost considerations should include all relevant costs and be long-ter
m in nature. Obviously, the buying firm will compare production and purchase cos
ts. Burt, Dobler, and Starling provide the major elements included in this compa
rison. 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 outsi
de source. If a firm does not currently have the capacity to make the part, incr
emental costs will include variable costs plus the full portion of fixed overhea
d 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 pr
oduction of the parts are considered incremental. That is, fixed costs, under co
nditions of sufficient idle capacity, are not incremental and should not be cons
idered as part of the cost to make the part.
While cost is seldom the only criterion used in a make-or-buy decision, simple b
reak-even analysis can be an effective way to quickly surmise the cost implicati
ons within a decision. Suppose that a firm can purchase equipment for in-house u
se for $250,000 and produce the needed parts for $10 each. Alternatively, a supp
lier could produce and ship the part for $15 each. Ignoring the cost of negotiat
ing a contract with the supplier, the simple break-even point could easily be co
mputed:
$250,000 + $10Q = $15Q
$250,000 = $15Q â $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. How
ever, 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), makin
g the prospect of making the part too cost efficient to ignore.
Stanley Gardiner and John Blackstone's 1991 paper in the International Journal o
f 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 Blackston
e's method did not guarantee a best solution for a complicated make-or-buy probl
em. Therefore, they offer an updated, enhanced approach using spreadsheets with
built-in liner programming (LP) capability to provide "what if" analyses to enco
urage efforts toward finding an optimal solution.
Firms have started to realize the importance of the make-or-buy decision to over
all manufacturing strategy and the implication it can have for employment levels
, asset levels, and core competencies. In response to this, some firms have adop
ted total cost of ownership (TCO) procedures for incorporating non-price conside
rations into the make-or-buy decision.
SEE ALSO: Break-Even Point
R. Anthony Inman
FURTHER READING:
Balakrishnan, Jaydeep, and Chun Hung Cheng. "The Theory of Constraints and the M
ake-or-Buy Decision: An Update and Review." Journal of Supply Chain Management:
A Global Review of Purchasing & Supply 41, no. 1 (2005): 40â 47.
Burt, David N., Donald W. Dobler, and Stephen L. Starling. World Class Supply Ma
nagement: 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' a
nd the Make-or-Buy Decision." International Journal of Purchasing & Materials Ma
nagement 27, no. 3 (1991): 38â 43.
Wisner, Joel D., G. Keong Leong, and Keah-Choon Tan. Principles of Supply Chain
Management: A Balanced Approach. Mason, OH: Thomson South-Western, 2005.

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