Chapter(8): Make Or Buy Decision
Introduction:
In the process of carrying out business
activities of an organization, a component/
product can be made within the organization
or bought from a subcontractor.
Each decision involves its own costs.
So, in a given situation,
the organization should evaluate each of the
above make or buy alternatives and then
select the alternative which results in the
lowest cost. This is an important decision
since it affects the productivity of the
organization. In the long run, the make or buy
decision is not static.
The make option of a component/product may
be economical today; but after some time, it may
turn out to be uneconomical to make the same.
Thus, the make or buy decision should be
reviewed periodically, say, every 1 to 3 years.
This is mainly to cope with the changes in the
level of competition and various other
environmental factors.
Criteria For Make Or Buy
Criteria for make:
The following are the criteria for make:
1. The finished product can be made cheaper by
the firm than by outside suppliers.
2. 2. The finished product is being manufactured
only by a limited number of outside firms
which are unable to meet the demand.
3. The part has an importance for the firm
and requires extremely close quality
control.
4. The part can be manufactured with the
firm’s existing facilities and similar to other
items in which the company has
manufacturing experience.
Criteria for buy:
The following are the criteria for buy:
1. Requires high investments on facilities which
are already available at suppliers plant.
2. The company does not have facilities to make
it and there are more profitable opportunities
for investing company’s capital.
3. Existing facilities of the company can be used
more economically to make other parts.
4. The skill of personnel employed by the company
is not readily adaptable to make the part.
5. Patent or other legal barriers prevent the
company for making the part.
6. Demand for the part is either temporary or
seasonal.
Approaches For Make Or Buy Decision:
Types of analysis followed in make or buy
decision are as follows:
1. Simple cost analysis.
2. Economic analysis.
3. Break-even analysis.
Simple Cost Analysis:
The concept is illustrated using an example
problem.
Example.1:
A company has extra capacity that can be
used to produce a sophisticated fixture which
it has been buying for Rs. 900 each.
If the company makes the fixtures, it will incur
materials cost of Rs. 300 per unit,
labour costs of Rs. 250 per unit, and variable
overhead costs of Rs. 100 per unit.
The annual fixed cost associated with the
unused capacity is Rs. 10,00,000.
Demand over the next year is estimated at
5,000 units.
Would it be profitable for the company to
make the fixtures?
Solution:
We assume that the unused capacity has alternative use.
Cost to make:
Variable cost/unit = Material + labour + overheads
= Rs. 300 + Rs. 250 + Rs. 100 = Rs. 650
Total variable cost = (5,000 units) (Rs. 650/unit)= Rs. 32,50,000
Add fixed cost associated with unused capacity + Rs. 10,00,000
Total cost = Rs. 42,50,000
Cost to buy:
Purchase cost = (5,000 units) (Rs. 900/unit) = Rs. 45,00,000
Add fixed cost associated with unused capacity + Rs. 10,00,000
Total cost = Rs. 55,00,000
The cost of making fixtures is less than the cost of
buying fixtures from outside. Therefore, the organization
should make the fixtures.
Economic Analysis:
The following inventory models are
considered to illustrate this concept:
Purchase model Manufacturing model
The formulae for EOQ and total cost (TC) for
each model are given in the following table:
Purchase model Manufacturing model
Where:
D= demand/year.
P= purchase price/unit.
Cc = carrying cost/unit/year.
Co= ordering cost/order or set-up cost/set-up.
k= production rate (No. of units/year).
r= demand/year.
Q1 = economic order size.
Q2 = economic production size.
TC= total cost per year.
Example.2:
An item has a yearly demand of 2,000 units.
The different costs in respect of make and buy
are as follows. Determine the best option.
Buy Make
Item cost/unit Rs. 8.00 Rs. 5.00
Procurement cost/order Rs. 120.00
Set-up cost/set-up Rs. 60.00
Annual carrying Rs. 1.60 Rs. 1.00
cost/item/year
Production rate/year 8,000 units
Solution:
Buy option:
D= 2,000 units/year
Co = Rs. 120/order
Cc = Rs. 1.60/unit/year
Make option:
Co= Rs. 60/set-up.
r= 2,000 units/year.
Cc = Re 1/unit/year.
k= 8,000 units/year.
Result: The cost of making is less than the cost
of buying. Therefore, the firm should go in for
the making option.
Break-even Analysis:
The break-even analysis chart is shown in Fig.1.
In the figure
Fig.1 Break-even chart. Total cost (TC)
Profit
Sales(S)
A
B
Variable cost (VC)
Loss Fixed cost(FC)
C
Production Quantity
TC= total cost
FC= fixed cost
TC= FC+ variable cost
B= the intersection of TC and sales (no loss or no gain
situation).
A= break-even sales
C= break-even quantity/break-even point (BEP)
The formula for the break-even point (BEP) is
BEP = FC
Selling price/unit Variable cost/unit.
Example.3:
A manufacturer of TV buys TV cabinet at Rs.
500 each. In case the company makes it
within the factory, the fixed and variable
costs would be Rs. 4,00,000 and Rs. 300 per
cabinet respectively.
Should the manufacturer make or buy the
cabinet if the demand is 1,500 TV cabinets?.
Solution:
Selling price/unit (SP) = Rs. 500
Variable cost/unit (VC) = Rs. 300
Fixed cost (FC) = Rs. 4,00,000
BEP = 4, 00, 000 = 2,000 units
500- 300
Since the demand (1,500 units) is less
than the break-even quantity, the
company should buy the cabinets for its
TV production.
Example.4:
There are three alternatives available to meet the
demand of a particular product. They are as
follows:
(a) Manufacturing the product by using process A.
(b) Manufacturing the product by using process B.
(c) Buying the product.
The details are as given in the following table:
Cost elements Manufacturing Manufacturing Buy
the product by the product by
process A process B
Fixed 5,00,000 6,00,000
cost/year (Rs.)
Variable/unit 175 150
(Rs.)
Purchase 125
price/unit (Rs.)
The annual demand of the product is 8,000
units. Should the company make the product
using process A or process B or buy it?
Solution:
Annual cost of process A = FC + VC × Volume
= 5,00,000 + 175 × 8,000 = Rs. 19,00,000
Annual cost of process B = FC + VC × Volume
= 6,00,000 + 150 × 8,000 = Rs. 18,00,000
Annual cost of buy = Purchase price/unit ×Volume
= 125 × 8,000 = Rs. 10,00,000
Since the annual cost of buy option is the
minimum among all the alternatives, the
company should buy the product.
Questions
1. Briefly explain the various criteria for
make or buy decisions.
2. What are the approaches available for
make or buy decisions? Explain any one of
them with a suitable example.
3. An automobile company has extra capacity that
can be used to produce gears that the company has
been buying for Rs. 300 each. If the company makes
gears, it will incur materials cost of Rs. 90 per unit,
labour costs of Rs. 120 per unit, and variable
overhead costs of Rs. 30 per unit. The annual fixed
cost associated with the unused capacity is Rs.
2,40,000. Demand for next year is estimated at 4,000
units.
(a) Would it be profitable for the company to make the
gears?
(b) Suppose the capacity could be used by another
department for the production of some agricultural
equipment that would cover its fixed and variable cost
and contribute Rs. 90,000 to profit which would be
more advantageous, gear production or agricultural
equipment production?
4. An item has an yearly demand of 1,000 units. The
different costs with regard to make and buy are as
follows. Determine the best option.
Buy Make
Item cost/unit Rs. 6.00 Rs. 5.90
Procurement cost/order Rs. 10.00
Set-up cost/set-up Rs. 50.00
Annual carrying Rs. 1.32 Rs. 1.30
cost/item/year
Production rate/year 6,000 units
5. A manufacturer of motor cycles buys side
boxes at Rs. 240 each. In case he makes it
himself, the fixed and variable costs would
be Rs. 30,00,000 and Rs. 90 per side box
respectively. Should the manufacturer make
or buy the side boxes if the demand is 2,500
side boxes?
Thank You