Make or Buy and Other Short-Term Decisions

30/07/2020 0 By indiafreenotes

The make-or-buy decision is the action of deciding between manufacturing an item internally (or in-house) or buying it from an external supplier (also known as outsourcing). Such decisions are typically taken when a firm that has manufactured a part or product, or else considerably modified it, is having issues with current suppliers, or has reducing capacity or varying demand.

Another way to define make-or-buy decision that is closely related to the first definition is this: a decision to perform one of the activities in the value chain in-house, instead of purchasing externally from a supplier. A value chain is the complete range of tasks such as design, manufacture, marketing and distribution of a product / service that businesses must get done to take a service or product from conception to their customers.

Some companies manage all of the tasks in the value chain from manufacturing raw materials all through to the ultimate distribution of the completed goods and provision of after-sales services. Some other companies are happy just to integrate on a smaller scale by buying a lot of the parts and materials that are required for their finished products. When a business is involved in more than one activity in the whole value chain, it is vertically integrated. This kind of integration is quite common.

Vertical integration provides its own set of advantages. An integrated company depends less on its suppliers and so can be certain of a smoother flow of materials and parts for the manufacture than a non-integrated company. In addition, some companies believe they can manage quality better by manufacturing their own parts and materials instead of depending on the quality control standards of external suppliers. What’s more, an integrated company realizes revenue from the parts and material that it is “making” rather than “buying” in addition to income from its usual operations.

The benefits of vertical integration are counterbalanced by the benefits of using outside suppliers. By combining demand from different companies, a supplier can enjoy economies of scale. These economies of scale can cause better quality and lower expenses than would be possible if the business were to endeavor to manufacture the parts or provide a service by itself. At the same time, a business should be careful to retain control over those tasks that are necessary for maintaining its competitive position.

Factors Influencing the Decision

To come to a make-or-buy decision, it is essential to thoroughly analyze, all of the expenses associated with product development in addition to expenses associated with buying the product. The assessment should include qualitative and quantitative factors. It should also separate relevant expenses from irrelevant ones and consider only the former. The study should also look at the availability of the product and its quality under each of the two situations.

Introduction to quantitative and qualitative analysis

Quantitative aspects can be calculated and compared whereas qualitative aspects call for subjective judgment and, frequently require multiple opinions. In addition, some of the associated factors can be quantified with sureness while it is necessary to estimate other factors. The make-or-buy decision calls for a thorough assessment from all angles.

Quantitative aspects are essentially the incremental costs stemming from making or purchasing the component. Factors of this type to look at may incorporate things such as availability of manufacturing facilities, needed resources and manufacturing capacity. This may also incorporate variable and fixed expenses that can be found out either by way of estimation or with certainty. Similarly, quantitative expenses would incorporate the cost of the good under consideration as the price is determined by suppliers offering the product for sale in the marketplace.

Qualitative factors to look at call for more subjective assessment. Examples of such factors include control over component quality, the reliability and reputation of the suppliers, the possibility of modifying the decision in the future, the long-term viewpoint concerning manufacture or purchase of the product, and the impact of the decision on customers and suppliers.

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 (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