Make Or Buy Decision

The make-or-buy decision (outsourcing) describes to make a strategic choice between producing an item internally or buying this externally . This decision  usually make when a firm that has developed/modified a product or part in changing enviroment.

If the purchase price for a product is higher than to make it, or if the manufacturer has excess capacity that could be used for that product, or suppliers are unreliable, manufacturer prefer to make the product. This assumes the manufacturer has the skills and equipment necessary, access to raw materials, and the ability to meet its own product standards. A company who chooses to make rather than buy is at risk of losing alternative sources, design flexibility, and access to technological innovations.

BASIC CONCEPTS

The process consists of four stages as summarised next.

 Stage 1 refers to the preparations phase, which entails creating a multi-disciplinary team, selecting the part, assembly or family of parts for analysis and briefing the team. 

 Stage 2 is concerned with data collection. Here, three workshops are organised in order to collect the information required to carry out the analysis. Workshop 1 consists of prioritising the make-or-buy areas and factors. Using the rankings, weightings are generated using the centroid method  The weightings generated should reflect the relative importance of each area and its sub-factors to the decision under consideration. Workshop 2 is concerned with the assessment of internal and external capabilities using a set of proformas, which cover the four relevant areas. These proformas use a five-point scale for the assessment. Workshop 3 consists of capturing the costs incurred in both producing internally and externally. These costs are then compared and rated on a five-point scale. 

 Stage 3 consists of data analysis using a spreadsheet which provides the following:

• Final scores for in-house and for the supplier. The highest score indicates the best option. 
• Weighted gaps for each factor area, highlighting the strengths and weaknesses of this option. 
• A sensitivity analysis which tests the robustness of the final outcome. 

 Stage 4 consists of feeding back the results to the team. 

Strategic and operational level make control of this analysis. Strategic level  analize future in the current enviroment. Government regulations, competing firms, and market have a strategic impact on this decision..

If the company determines that the open market is the best source for a particular component or support service, then the firm should buy the item or service. If the company decides that the part or function should be supplied by company employees, then the firm has taken the “make” choice

Make-or-buy decisions determine the firm’s level of vertical integration, since each decision specifies which operations the firm will engage in and which it will contract out to a supplier. Although a number of ways of managing the buyer-supplier relationship have been identified, based on behavioral (Ouchi,1980), strategic (Harrigan, 1983), or industrial economic (Blois, 1972) assumptions, here we focus on the prototypical choice between making a component within the firm or buying the component in a market partly regulated by competitive forces

Anderson (1982) showed that high asset specificity, uncertainty, and their interaction were associated with the decision to sell through an internal sales force ratherthan through independent marketing representatives. Anderson measured asset specificity as the extent of specialization in knowledge or working relationships between the salesperson and the company or the customer and assessed two types of uncertainty: the difficulty of evaluating performance and environmental unpredictability. Monteverde and Teece (1982a) found a strong effect, in the predicted direction, of asset specificity on backward integration into component production by General Motors and Ford. Monteverde and Teece measured asset specificity as an expert’s subjective assessment of the amount of engineering effort invested by the buyer firm in developing a component. These studies provide important background forthe present research in the way they applied transaction cost analysis to the study of vertical integration.

Thus uncertainty in the decision maker’s environment is closely reiated to environmentai compiexity, and both are reievant to the efficient boundaries modei to the extent that they introduce problems of bounded rationality in contracting between buyer and supplier (Williamson,1975: 21-23). Wiiliamson (1979) argued that uncertainty raises the costs of executing market transactions only when opportunism is present. In a competitive market, where asset specificity is low, buyers can recontract with other suppliers if changes in contract specifications need to be made. On the other hand, if either little or no uncertainty is associated with a transaction, the buyer can specify all (or almost alt) the contingencies that might impinge on contract execution and thus defend against supplier opportunism. Thus, according to Williamson’s model, uncertainty and supplier asset specificity are joint conditions for a decision to make a component.

HYPOTHESIS

Hypothesis 1 (Hi): Volume uncertainty leads to making rather than buying a component.

Hypothesis 2 (Hg): Technological uncertainty increases the likelihood of a make rather than a buy decision.

Hypothesis3(H3): The higher the supplier production cost advantage, the more likely the firm is to buy rather than make a component

Hypothesis 4 (H*): The competitiveness of the supplier market increases the production cost advantage of suppliers over buyers

Hypothesis 5 {H5): Greater supplier market competition should lead to buying the component

Hypothesis 6 (Hg): The experience a buyer has in producing a component reduces the production cost advantage of the supplier over the buyer.

Hypothesis 7 {H7): Buyer experience in producing a componen increases the likelihood of a buy decision

Hypothesis 8 (Ha): Buyerexperience in component production reduces technological uncertainty associated with the component

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 

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 outside source. If a firm does not currently have the capacity to make the part, incremental costs will include variable costs plus the full portion of fixed overhead 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 production of the parts are considered incremental. That is, fixed costs, under conditions of sufficient idle capacity, are not incremental and should not be considered as part of the cost to make the part.

Stanley Gardiner and John Blackstone’s 1991 paper in the International Journal of 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 Blackstone’s method did not guarantee a best solution for a complicated make-or-buy problem. Therefore, they offer an updated, enhanced approach using spreadsheets with built-in liner programming (LP) capability to provide “what if” analyses to encourage efforts toward finding an optimal solution.

CONCLUSION

Firms have started to realize the importance of the make-or-buy decision to overall manufacturing strategy and the implication it can have for employment levels, asset levels, and core competencies. In response to this, some firms have adopted total cost of ownership (TCO) procedures for incorporating non-price considerations into the make-or-buy decision.