Make or Buy Decision

Sometimes a firm may have to face a problem as to whether a part should be produced or the same should be purchased from the outside open market.

In this case, the following two points should carefully be considered:

(a) The Marginal Cost of the product; and

(b) Whether surplus capacity is available.

Needless to mention here that the decision in such a case is taken after comparing the price which has to be paid and the savings which can also be effected in terms of Marginal

Cost, as question of savings usually does not arise in case of fixed cost.

In other words, if the marginal costs are lower than the purchase price it may be suggested to produce that article in the factory itself.

Moreover, if the surplus capacity is not available and, at the same time, making the parts in the factory involves putting aside other work, the loss on contribution so made must also be considered together with marginal cost. In short, if the purchase price which are quoted by the outside sellers—is higher than the marginal cost plus a portion of fixed cost plus loss of contribution, the same may be produced by the factory.

Illustration:

A radio manufacturing company wants to make component X 273 Q, the same is available in the market at Rs. 5.75 each, with an assurance of continued supply.

The break-down of cost is:

• Should you make or Buy?
• What would be Your decision if the supplier offered component at Rs. 4.85 each?

Solution:

(a) Since the Marginal Cost of each component is Rs. 5, which is less than the purchase price of the open market of Rs. 5.75 each, it is recommended that the component should be manufactured by the company (if, however, the company is having spare capacity that cannot be filled with more remunerative jobs).

(b) If the purchase price in the open market is Rs. 4.85, which is less than the marginal cost Rs. 5.00, leaving a saving of Re. 0.15 per unit, it is recommended that the component should be purchased from the outside market as there is continued supply also. The spare capacity may be utilised for other purposes.

A make and buy decision is the act of choosing between manufacturing a product in-house or purchasing it from an external supplier. In a make-or-buy decision, the most important factors to consider are part of quantitative analysis, such as the associated costs of production and whether the business can produce at required levels.

Also referred to as the outsourcing decision, the make-or-buy decision compares the costs and benefits associated with producing a necessary good or service internally to the costs and benefits involved in hiring an outside supplier for the resources in question. To compare costs accurately, a company must consider all aspects regarding the acquisition and storage of the items must.

Make and Buy Costs

Regarding in-house production, a business must include expenses related to the purchase and maintenance of any production equipment and the cost of production materials. Further make costs can include the additional labor required to produce the items, storage requirements within the facility or storage costs and the proper disposal of any remnants or byproducts from the production process.

Buy costs related to purchasing the products from an outside source must include the price of the good itself, any shipping or importing fees, and applicable sales tax charges. Additionally, the company must factor in the expenses relating to the storage of the incoming product and labor costs associated with receiving the products into inventory.

Decision-Making Points

The results of the quantitative analysis may be sufficient to make a determination based on the approach that is more cost-effective. At times, qualitative analysis addresses any concerns a company cannot measure specifically.

Factors that may influence a firm’s decision to buy a part rather than produce it internally include a lack of in-house expertise, small volume requirements, a desire for multiple sourcing and the fact that the item may not be critical to the firm’s strategy. A company may give additional consideration if the firm has the opportunity to work with a company that has previously provided outsourced services successfully and can sustain a long-term relationship.

Similarly, factors that may tilt a firm toward making an item in-house include existing idle production capacity, better quality control or proprietary technology that needs to be protected. A company may also consider concerns regarding the reliability of the supplier, especially if the product in question is critical to normal business operations. The firm should also consider whether the supplier can offer the desired long-term arrangement.

Objective of Make and Buy Decision

• Receives purchase requisition and inquires to suppliers about the materials being requested.
• Costs reduction through negotiation or supplier development.
• Prepares purchase order for the selected supplier for the requested materials, etc…
• Responsible for searching low price but fair quality suppliers.
• Negotiates possibility of consignment between supplier and the company>
• Improved availability of vital items and reduced desirable items by constant monitoring. Identified Vendors for regular and prompt delivery of vital items thereby reducing the inventory by Just in Time supply (JIT) for many A class items