Should you make or buy?

Formulation of the problem

In a make-or-buy or outsourcing decision, the two decision alternatives are 1) making a component or 2) buying it from a supplier.

Outsourcing is a process of buying resources from an outside supplier instead of manufacturing them in-house.

In a make-or-buy decision, managers must decide whether their companies should manufacture some parts and components for their products in-house or contract with another company to supply these parts and complements.

This is a short-term decision only if no investment or disinvestment are considered. If the current situation is buying and the decision is to switch to making, the company should be able to make the component mostly with the available capacity and little additional investment. If the current situation is making and the decision is to switch to buying, the company should keep most of the productive equipment and reallocate it to other uses, unless the component is planned to be discontinued on the short term.

Classification based on relevance

Such a decision typically does not affect revenues. Assuming the supplier provides the same quality, neither sales volume nor selling prices are affected. However, this decision changes variable and fixed costs and therefore the cost structure. It also affects capacity usage as outsourcing may free some resources which could be allocated to other activities and thus deployed to some better use.

If the company makes and considers buying, only manufacturing costs are thus relevant, and more specifically variable costs (e.g. raw materials, energy, etc.), direct discretionary fixed cost (e.g. training of the employees producing the component), and some direct capacity fixed costs (e.g. wages of employees dedicated to the component). Some and not all, because depreciation of the dedicated equipment is a sunk cost, and if selling the equipment is an option, the decision becomes a long-term decision with very different cash flows over the years.

In general, unless you have more information, indirect fixed costs which are allocated to the component must be assumed irrelevant to the decision. They are common costs, there is no guarantee they may instead be reallocated to other uses. This brings the question of the opportunity costs of making which arise when demand exceeds available capacity. If the company chooses to buy, it frees some capacity and may generate additional contribution margin by reallocating it to other products.

Net Economic Impact and indifference points

In the next video, I compute the net economic impact of buying Cosmos instead of making them. You can download here data and solutions. In this example, I found a supplier who could sell them to me for 4 euros per unit. This is higher than my unit variable cost of production of 3.5 (indeed, since I keep selling, the variable costs of sales are irrelevant), so I loose 0.5 on each unit. However, I can save 750 euros on my fixed production costs. The questions I can answer with the following information are:

  • Knowing the sales volume of Cosmo is 1,000, what is the net economic impact of buying instead of making?
  • At which volume of activity am I indifferent between making and buying (indifference point in volume \(Q\))?
  • For which supplier’s price am I indifferent between making and buying (indifference point in unit purchasing price, \(P\))?
  • For which amount of fixed costs saved am I indifferent between making and buying (indifference point in fixed cost change \(\Delta FC\))?

Try to compute the net economic impact and the indifference point in volume, suppliers’ price, and fixed cost saved. To do this, you can use the following equation showing the two impacts at work in this example: \(\Delta V_c = P - V_c\) is the change in unit variable cost (4-3.5; exceptionally, P refers here to the suppliers’ price) and \(\Delta FC\) is the change in fixed costs (-750):

\[ \begin{aligned} NEI & = - Q \times \Delta V_c - \Delta FC \\ & = - Q \times (P - V_c) - \Delta FC \end{aligned} \]

Qualitative factors

In terms of risks, three concerns should be addressed. First, it is important to ascertain that the supplier is able to reliably deliver the same or even higher levels of quality (competency). Indeed, the company may be liable, or at least suffer great reputation costs if quality suffers. Second, it is also important to check that the supplier has the capacity to finance the activity. A preliminary analysis of financial statements can help assess risks of bankruptcy (liquidity and solvability). Third, in-sourcing and out-sourcing affect the cost structure and therefore the degree of operating leverage. It is therefore important to take into account sales trend and volatility and the current sensitivity of operating income to changes in revenues.

In terms of strategy, outsourcing may or may not be consistent with the company’s policy. In general, activities which are key to building a competitive advantage should not be outsourced. Moreover, outsourcing is also inconsistent with strategies of vertical integration where companies attempt to control the whole value chain.

Finally, in terms of corporate social and environmental responsibility, several questions should be addressed: what is the impact on local employment and employee morale, especially if there are some terminations? Is the supplier providing decent wages and decent working conditions to its own employees? Is the supplier respectful of the environment? In a decision to outsource, the company is responsible for the choice of the suppliers and therefore the practices it condones and supports by making business with them.

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