Make or Buy Decision in Operations Management

Objec­tive and basic idea#

The main objec­tive is to choose the option that gives the required qual­ity, quan­tity and reli­a­bil­ity at the low­est rel­e­vant total cost, while sup­port­ing the fir­m's long-term strat­egy.

The basic idea is to com­pare two things:

• the rel­e­vant cost of mak­ing the item inter­nally, and
• the total cost of buy­ing it from out­side,

and then to adjust the answer for non-cost fac­tors such as qual­ity, capac­ity, sup­plier reli­a­bil­ity, secrecy and strat­egy. Cost is usu­ally the start­ing point, but it is rarely the only point.

When does the deci­sion arise?#

• A new prod­uct needs parts the firm has never made or bought before.
• An exist­ing sup­plier raises prices, deliv­ers late or sup­plies poor qual­ity.
• The firm has spare capac­ity and looks for work to fill it.
• Demand grows beyond inter­nal capac­ity.
• Costs of inter­nal pro­duc­tion rise, or new tech­nol­ogy changes the eco­nom­ics.
• Man­age­ment reviews which activ­i­ties are core and which can be out­sourced.

Mean­ing of "make" and "buy"#

Make#

The organ­i­sa­tion uses its own machines, work­ers, mate­ri­als and man­age­ment to pro­duce the item. It con­trols the process fully but also car­ries the invest­ment, fixed costs and risks.

Buy#

The organ­i­sa­tion pur­chases the fin­ished item or ser­vice from a sup­plier. It pays a price per unit (plus order­ing, trans­port, inspec­tion and sim­i­lar costs) and relies on the sup­plier for qual­ity and deliv­ery.

Why com­pa­nies choose to make#

Lower cost of inter­nal pro­duc­tion#

If the rel­e­vant inter­nal cost is below the pur­chase price, mak­ing saves money, espe­cially at high vol­umes.

Bet­ter qual­ity con­trol#

The firm can set and check its own stan­dards directly.

Bet­ter con­fi­den­tial­ity#

Designs, for­mu­las and processes stay inside the firm, pro­tect­ing trade secrets.

Bet­ter use of spare capac­ity#

Idle machines and work­ers can be put to work, spread­ing fixed costs over more out­put.

Reli­able sup­ply#

The firm is less exposed to sup­plier delays, strikes or short­ages.

Other rea­sons include no suit­able sup­plier exist­ing, the item being a core com­pe­tence, and the wish to keep skilled work­ers employed.

Why com­pa­nies choose to buy#

Lower pur­chase cost#

Spe­cial­ist sup­pli­ers often enjoy economies of scale, expe­ri­ence and lower over­heads.

Lack of inter­nal capac­ity#

Exist­ing facil­i­ties are fully used, and adding capac­ity would be costly or slow.

Lack of tech­ni­cal skill#

The firm may not have the tech­nol­ogy, patents or exper­tise needed.

Time sav­ing#

Buy­ing is faster than set­ting up a new pro­duc­tion line.

Focus on core activ­i­ties#

Man­age­ment can con­cen­trate money and atten­tion on what gives the firm its com­pet­i­tive advan­tage.

Buy­ing also offers flex­i­bil­ity: order quan­ti­ties can be changed when demand changes, with­out the bur­den of idle plant.

Cost fac­tors in the make-or-buy deci­sion#

Inter­nal cost of mak­ing#

• Direct mate­ri­als
• Direct labour
• Vari­able over­heads, such as power and con­sum­ables
• Addi­tional fixed costs, such as new machines, tool­ing and super­vi­sion
• Oppor­tu­nity cost of capac­ity used, if that capac­ity could earn some­thing else

Exter­nal cost of buy­ing#

• Pur­chase price per unit
• Freight, pack­ing and insur­ance
• Order­ing, receiv­ing and inspec­tion costs
• Import duties and taxes that can­not be recov­ered
• Cost of hold­ing extra safety stock against sup­plier delays

Role of fixed and vari­able cost#

Vari­able cost changes with the num­ber of units made, for exam­ple mate­r­ial and piece-rate labour. Fixed cost stays the same over a range of out­put, for exam­ple machine depre­ci­a­tion, rent and salaried super­vi­sion. Mak­ing usu­ally involves a fixed cost plus a lower vari­able cost per unit; buy­ing usu­ally involves only a per-unit price. So:

• mak­ing becomes eco­nom­i­cal at high vol­umes, because the fixed cost is spread over many units;
• buy­ing is eco­nom­i­cal at low vol­umes, because the firm avoids a fixed cost it can­not spread.

A key rule is to con­sider only rel­e­vant costs, that is, future costs that dif­fer between the two options. Fixed over­heads that will be incurred any­way, whether the item is made or bought, are not rel­e­vant and should be ignored.

Break-even point in make or buy#

The break-even (indif­fer­ence) quan­tity is the vol­ume at which the total cost of mak­ing equals the total cost of buy­ing. Let $F$ = fixed cost of mak­ing, $V$ = vari­able cost of mak­ing per unit, $P$ = pur­chase price per unit and $Q$ = quan­tity.

$$F + VQ = PQ$$

$$\displaystyle Q^{*} = \frac{F}{P - V}$$

If expected demand is above $Q^{*}$, mak­ing is cheaper. If it is below $Q^{*}$, buy­ing is cheaper. The for­mula works only when the pur­chase price is higher than the vari­able cost of mak­ing ($P > V$); oth­er­wise buy­ing is always cheaper on cost alone.

Worked exam­ple 1: break-even quan­tity#

Sup­pose a pump man­u­fac­turer needs a machined bracket. A sup­plier quotes ₹100 per unit. To make it, the firm would spend ₹30,000 a year on tool­ing and set-up (fixed) and ₹70 per unit on mate­r­ial, labour and power (vari­able).

Step 1: Write the data. $F = 30{,}000$, $V = 70$, $P = 100$.

Step 2: Break-even quan­tity.

$$\displaystyle Q^{*} = \frac{30{,}000}{100 - 70} = \frac{30{,}000}{30} = 1{,}000 \text{ units}$$

At 1,000 units both options cost $30{,}000 + 70 \times 1{,}000 = 1{,}00{,}000$ rupees, and $100 \times 1{,}000 = 1{,}00{,}000$ rupees.

Step 3: Test at 1,500 units.

$$\text{Make} = 30{,}000 + 70 \times 1{,}500 = 30{,}000 + 1{,}05{,}000 = 1{,}35{,}000$$

$$\text{Buy} = 100 \times 1{,}500 = 1{,}50{,}000$$

Mak­ing saves ₹15,000, so the firm should make.

Step 4: Test at 800 units.

$$\text{Make} = 30{,}000 + 70 \times 800 = 30{,}000 + 56{,}000 = 86{,}000$$

$$\text{Buy} = 100 \times 800 = 80{,}000$$

Buy­ing saves ₹6,000, so the firm should buy.

Inter­pre­ta­tion: above 1,000 units a year mak­ing is more eco­nom­i­cal; below 1,000 units buy­ing is more eco­nom­i­cal.

Worked exam­ple 2: rel­e­vant costs and oppor­tu­nity cost#

Sup­pose a firm cur­rently makes 5,000 units a year of a com­po­nent. Its cost sheet shows:

A sup­plier offers the com­po­nent at ₹90 per unit. At first sight buy­ing saves ₹10 per unit.

Step 1: Iden­tify rel­e­vant cost. The gen­eral fixed over­heads (fac­tory rent, man­ager's salary) will con­tinue even if the firm buys, so they are not rel­e­vant. Rel­e­vant cost of mak­ing is

$$40 + 25 + 15 = 80 \text{ rupees per unit}$$

Step 2: Com­pare with no alter­na­tive use of capac­ity.

$$\text{Make} = 80 \times 5{,}000 = 4{,}00{,}000, \qquad \text{Buy} = 90 \times 5{,}000 = 4{,}50{,}000$$

Mak­ing is cheaper by ₹50,000, so the firm should con­tinue to make, even though the full cost of ₹100 looked higher than the price.

Step 3: Add an oppor­tu­nity cost. Now sup­pose that if the firm buys, the freed space and machines can be rented out for ₹70,000 a year. That lost rent is a cost of mak­ing.

$$\text{Make} = 4{,}00{,}000 + 70{,}000 = 4{,}70{,}000, \qquad \text{Buy} = 4{,}50{,}000$$

Now buy­ing is cheaper by ₹20,000, so the firm should buy and rent out the capac­ity. The les­son is that spare capac­ity favours mak­ing, while capac­ity with a prof­itable alter­na­tive use favours buy­ing.

Non-cost fac­tors#

Qual­ity#

If the firm can achieve bet­ter or more con­sis­tent qual­ity inter­nally, mak­ing may be pre­ferred even at a higher cost. If a spe­cial­ist sup­plier has supe­rior tech­nol­ogy and cer­ti­fied qual­ity sys­tems, buy­ing may give bet­ter qual­ity.

Capac­ity#

If spare capac­ity exists, mak­ing uses resources that would oth­er­wise be idle, and only vari­able costs are rel­e­vant. If no spare capac­ity exists, mak­ing would need new invest­ment or would dis­place other prof­itable work, so buy­ing often becomes attrac­tive.

Sup­plier reli­a­bil­ity#

A cheap sup­plier who deliv­ers late or incon­sis­tently can stop pro­duc­tion. The firm should exam­ine the sup­pli­er's deliv­ery record, finan­cial strength, capac­ity, loca­tion and the num­ber of alter­na­tive sup­pli­ers avail­able.

Strate­gic fac­tors#

Items that form the fir­m's core com­pe­tence or give it a com­pet­i­tive edge are usu­ally kept in-house. Out­sourc­ing them can cre­ate future com­peti­tors and loss of skills. Non-core, stan­dard items are good can­di­dates for buy­ing.

Other fac­tors#

• Con­fi­den­tial­ity of designs and processes
• Flex­i­bil­ity to change vol­umes or designs
• Labour rela­tions, since out­sourc­ing may lead to job losses
• Con­trol over lead time and deliv­ery sched­ules
• Risk from cur­rency changes, trans­port dis­rup­tion or sup­plier fail­ure

Advan­tages and dis­ad­van­tages#

Make or buy ver­sus ordi­nary pur­chas­ing#

Make or buy in man­u­fac­tur­ing and ser­vices#

Man­u­fac­tur­ing: auto­mo­bile firms buy tyres, bat­ter­ies and elec­tron­ics while mak­ing engines; elec­tron­ics com­pa­nies out­source assem­bly to con­tract man­u­fac­tur­ers; gar­ment exporters buy fab­ric and make gar­ments.

Ser­vices: com­pa­nies out­source pay­roll, secu­rity, clean­ing, can­teen, IT sup­port and call-cen­tre work; hos­pi­tals out­source lab­o­ra­tory tests or laun­dry; col­leges out­source trans­port. The same cost and non-cost logic applies.

Steps in mak­ing the deci­sion#

1. Define the item, required qual­ity and expected vol­ume.
2. Esti­mate the rel­e­vant cost of mak­ing, includ­ing new fixed costs and oppor­tu­nity cost.
3. Obtain quo­ta­tions and esti­mate the total cost of buy­ing.
4. Com­pute the break-even quan­tity and com­pare with expected demand.
5. Assess non-cost fac­tors: qual­ity, capac­ity, sup­plier reli­a­bil­ity, strat­egy, risk.
6. Decide, imple­ment, and review the deci­sion peri­od­i­cally as con­di­tions change.

Key terms#

Make-or-buy deci­sion

The choice between pro­duc­ing an item inter­nally and pur­chas­ing it from out­side.

Insourc­ing

Per­form­ing an activ­ity or mak­ing an item within the organ­i­sa­tion.

Out­sourc­ing

Obtain­ing an item or ser­vice from an exter­nal sup­plier.

Rel­e­vant cost

A future cost that dif­fers between the alter­na­tives being com­pared.

Oppor­tu­nity cost

The ben­e­fit given up by using a resource for one pur­pose rather than its best alter­na­tive.

Break-even quan­tity

The vol­ume at which the total cost of mak­ing equals the total cost of buy­ing.

Fixed cost

A cost that does not change with out­put over a rel­e­vant range.

Vari­able cost

A cost that changes in direct pro­por­tion to out­put.

Core com­pe­tence

A capa­bil­ity that gives the firm its com­pet­i­tive advan­tage and is hard to copy.

Com­mon ques­tions#

What is the for­mula for break-even quan­tity in a make-or-buy deci­sion?#

Break-even quan­tity equals the fixed cost of mak­ing divided by the dif­fer­ence between the pur­chase price per unit and the vari­able cost of mak­ing per unit. With ₹30,000 fixed cost, ₹100 price and ₹70 vari­able cost, it is 1,000 units.

Should allo­cated fixed over­heads be included in the cost of mak­ing?#

Only if they would be saved by buy­ing. Fixed over­heads that con­tinue what­ever the deci­sion are not rel­e­vant and should be excluded, as worked exam­ple 2 shows.

How does spare capac­ity affect the deci­sion?#

With spare capac­ity, only vari­able costs of mak­ing are rel­e­vant, which usu­ally favours mak­ing. With­out spare capac­ity, the firm must add invest­ment or give up other prof­itable work, which usu­ally favours buy­ing.

Why might a firm make an item even when buy­ing is cheaper?#

To pro­tect trade secrets, con­trol qual­ity, secure sup­ply, keep a core com­pe­tence in-house or avoid depen­dence on a sin­gle sup­plier.

Is make or buy a one-time deci­sion?#

No. Vol­umes, prices, tech­nol­ogy and sup­plier per­for­mance change, so firms review make-or-buy choices peri­od­i­cally.

Ref­er­ences#

1. Heizer, J., Ren­der, B. and Mun­son, C. Oper­a­tions Man­age­ment: Sus­tain­abil­ity and Sup­ply Chain Man­age­ment. Pear­son.
2. Steven­son, W. J. Oper­a­tions Man­age­ment. McGraw-Hill Edu­ca­tion.
3. Chopra, S. and Meindl, P. Sup­ply Chain Man­age­ment: Strat­egy, Plan­ning, and Oper­a­tion. Pear­son.
4. Kra­jew­ski, L. J., Mal­ho­tra, M. K. and Ritz­man, L. P. Oper­a­tions Man­age­ment: Processes and Sup­ply Chains. Pear­son.
5. Chary, S. N. Pro­duc­tion and Oper­a­tions Man­age­ment. McGraw-Hill Edu­ca­tion (India).

Related read­ing#

• Sequenc­ing in Oper­a­tions man­age­ment
• What is Oper­a­tions Man­age­ment
• Types of Pro­duc­tion Sys­tems in Oper­a­tions Man­age­ment