Case Study 1

Make Versus Buy Case

Name: Muhammad Ali

Roll # BB-21-53
Class: BBA 7th (Morning)
Session: 2021-2025
Subject: Operations Management
Course Instructor: Prof. Dr. Muhammad Hassan
Submission Date: November 11, 2024
 Case Study 1
Make Versus Buy Case
ABC Ltd. is a manufacturing company engaged in the manufacturing of valves. They have been in the
business for last 3 years and have been manufacturing only one type of valves. They started their
business initially with sales of 10,000 valves per month and now they have grown the volume to
about 50,000 valves per month. They have been buying all the raw material for the valve and were
doing all the manufacturing in house. Now they have established themselves in the market and are
planning to expand and produce different varieties of valves. They have their plant in the main city
and the total area of the plant is 50,000 sq. ft. Now if they want to expand and continue doing all the
activities of manufacturing of all the varieties in house, they would need another 50,000 sq. ft. of the
area. In the recent times, the land prices in the area have more than doubled in the last 3 years and
still land is available with great difficulty. Mr. Mohan is the production head of ABC Ltd. and has been
successful with the production and the level is continuously increasing. But in recent times, he is
facing the problem of quality complaints which have gone up from average 0.2% in previous 2 years
to 0.5 % this year. Also, he is finding that there is a high level of dissatisfaction among the workers
regarding workload as well as salary levels. The workers are regularly complaining about the over
work.

Although, Mr. Mohan has found that the workers have been spending lot of time on tea breaks,
lunch breaks and even in between the production spending lot of time talking to each other. But,
due to insufficient workers and staff, he is unable to take strict action and the workers are taking
advantage of this situation. For completing the work and delivering the products timely, he has to
employ workers on overtime and his overtime cost has also increased 3 times. Mr. Mohan is worried
about the new expansion plan of the management and is worried where the new workers would
come from as he is already finding shortage of workers for the existing job. He has requested the
management not to go for expansion immediately and look at improving and consolidating the
existing set up. He has sent his request to Mr. S. Kumar Director - Operations.

Mr. Kumar has gone through the request of Mr. Mohan and called a meeting of all the department
heads and explained the situation to all concerned. The marketing manager has expressed very
bullish prospect about the company's growth and said that the company should take advantage of
growing economy and established brand image of the company and definitely go for expansion. The
finance manager also expressed that this will result in economy of scale for the products and will
further increase the profitability of the products. Mr. Mohan again expressed his problems regarding
availability of manpower as well as production control and effect on quality and productivity. The
Marketing manager asked the Production manager about the option of outsourcing. Mr. Mohan is
skeptical about the outsourcing option as he felt that the outside agency will always charge more as
he will try to make his profit as well and also is worried about the possible problems of deliveries.
Mr. Kumar asked the Mr. Naresh who is the Purchase manager about his views. He said that since
the suppliers would also be interested in doing the business, they would not like to delay as with
delay they also incur loss. The Finance manager said that we can look at cost comparison for buying
against in house manufacturing.
After listening to all the views, Mr. Kumar told Mr. Mohan to work out the cost of production for
future sales as per the forecast given by the Marketing department. He also told Mr. Naresh to
collect the details of the future requirements to get the purchase cost details for few components of
the valve.

Mr. Mohan and Mr. Naresh have collected their data and they have presented the data in the
meeting called by Mr. Kumar to review the plan. First the marketing head Mr. Suresh presented his
market forecast and then Mr. Mohan presented his report and explained the details as follows.

One supervisor with monthly salary of Rs. 5000 with expected increase of 10% per year.

Direct wages of worker as Rs. 4 per unit. With 10% reduction in second year, no change in 3rd year
and increase of 10% every subsequent year.

Material cost of Rs. 14 per unit with an increase of 10% every year. Power and fuel cost of Rs. 2 per
unit with increase of 10% every year.

Indirect labor as 50% of direct labor.

They will have to buy a new machine with a cost of Rs. 50 lac. With usable life of 5 years.

Mr. Naresh explained his details as follows:

Component price from supplier at Rs. 20 for the first 2 years with an increase of 10% every
subsequent year.

Transportation cost of Rs. 2 per unit for the first year with increase of Rs. 0.20 every subsequent
year.

Inventory cost (storage cost) as 5% per year of the basic material cost.

The Marketing manager has given the sales forecast for next 5 years as follows:

Year 1 2 3 4 5
Sales Quantity 300000 500000 700000 900000 1000000
Question 1. Based on this data, is it economical for ABC [Link] go for buying the product from
market or manufacturing in house.

Answer:

Given Data and Initial Setup

1. Sales Quantities (per year):

o Year 1: 300,000 units

o Year 2: 500,000 units

o Year 3: 700,000 units

o Year 4: 900,000 units

o Year 5: 1,000,000 units

2. Initial Costs for In-House Manufacturing:

o Supervisor's Salary: Rs. 5,000 per month (annual Rs. 60,000, with a 10% increase
each year)

o Direct Wages: Rs. 4 per unit (10% reduction in Year 2, 10% increase in Year 4
onwards)

o Material Cost: Rs. 14 per unit (increases by 10% each year)

o Power and Fuel: Rs. 2 per unit (increases by 10% each year)

o Indirect Labor: 50% of direct labor

o Machine Cost: Rs. 5,000,000 (depreciated evenly over 5 years)

3. Outsourcing Costs:

o Component Cost: Rs. 20 per unit (remains constant for the first two years, then
increases by 10% every year)

o Transportation Cost: Rs. 2 per unit (increases by Rs. 0.20 each year)

o Inventory (Storage) Cost: 5% of material cost per unit

Yearly Calculations for In-House Manufacturing

1. Direct Wages per Unit:

o Year 1: Rs. 4

o Year 2: Rs. 4 * (1 - 0.10) = Rs. 3.60

o Year 3: Rs. 3.60 (no change)

o Year 4: Rs. 3.60 * (1 + 0.10) = Rs. 3.96

o Year 5: Rs. 3.96 * (1 + 0.10) = Rs. 4.36

2. Material Cost per Unit:

o Year 1: Rs. 14

o Year 2: Rs. 14 * (1 + 0.10) = Rs. 15.40

o Year 3: Rs. 15.40 * (1 + 0.10) = Rs. 16.94

o Year 4: Rs. 16.94 * (1 + 0.10) = Rs. 18.63

o Year 5: Rs. 18.63 * (1 + 0.10) = Rs. 20.49

3. Power and Fuel Cost per Unit:

o Year 1: Rs. 2

o Year 2: Rs. 2 * (1 + 0.10) = Rs. 2.20

o Year 3: Rs. 2.20 * (1 + 0.10) = Rs. 2.42

o Year 4: Rs. 2.42 * (1 + 0.10) = Rs. 2.66

o Year 5: Rs. 2.66 * (1 + 0.10) = Rs. 2.93

4. Indirect Labor Cost per Unit (50% of Direct Labor):

o Year 1: Rs. 4 * 0.50 = Rs. 2

o Year 2: Rs. 3.60 * 0.50 = Rs. 1.80

o Year 3: Rs. 3.60 * 0.50 = Rs. 1.80

o Year 4: Rs. 3.96 * 0.50 = Rs. 1.98

o Year 5: Rs. 4.36 * 0.50 = Rs. 2.18

5. Supervisor’s Annual Salary:

o Year 1: Rs. 60,000

o Year 2: Rs. 60,000 * (1 + 0.10) = Rs. 66,000

o Year 3: Rs. 66,000 * (1 + 0.10) = Rs. 72,600

o Year 4: Rs. 72,600 * (1 + 0.10) = Rs. 79,860

o Year 5: Rs. 79,860 * (1 + 0.10) = Rs. 87,846

6. Total Cost per Unit for In-House Manufacturing (Summing Components):

Calculated by summing Direct Labor, Material, Power and Fuel, and Indirect Labor, then
multiplying by Sales Quantity for each year. Supervisor’s Salary and Machine Depreciation
(Rs. 1,000,000 per year) are added.
Year Sales Direct Material Power & Indirect Supervisor Machine Total In-House
Quantity Labor Cost per Fuel Cost Labor Salary Depreciation Cost
Cost per Unit per Unit per Unit
Unit
1 300,000 Rs. 4.00 Rs. 14.00 Rs. 2.00 Rs. 2.00 Rs. 60,000 Rs. 1,000,000 Rs. 7,660,000
2 500,000 Rs. 3.60 Rs. 15.40 Rs. 2.20 Rs. 1.80 Rs. 66,000 Rs. 1,000,000 Rs. 12,566,000
3 700,000 Rs. 3.60 Rs. 16.94 Rs. 2.42 Rs. 1.80 Rs. 72,600 Rs. 1,000,000 Rs. 18,824,600
4 900,000 Rs. 3.96 Rs. 18.63 Rs. 2.66 Rs. 1.98 Rs. 79,860 Rs. 1,000,000 Rs. 26,186,260
5 1,000,000 Rs. 4.36 Rs. 20.49 Rs. 2.93 Rs. 2.18 Rs. 87,846 Rs. 1,000,000 Rs. 31,773,446

Yearly Calculations for Outsourcing

1. Component Cost per Unit:

o Year 1: Rs. 20

o Year 2: Rs. 20

o Year 3: Rs. 20 * (1 + 0.10) = Rs. 22

o Year 4: Rs. 22 * (1 + 0.10) = Rs. 24.20

o Year 5: Rs. 24.20 * (1 + 0.10) = Rs. 26.62

2. Transportation Cost per Unit:

o Year 1: Rs. 2

o Year 2: Rs. 2 + 0.20 = Rs. 2.20

o Year 3: Rs. 2.20 + 0.20 = Rs. 2.40

o Year 4: Rs. 2.40 + 0.20 = Rs. 2.60

o Year 5: Rs. 2.60 + 0.20 = Rs. 2.80

3. Inventory Cost per Unit:

o 5% of Material Cost per unit (based on the in-house calculation for each year).

4. Total Cost per Unit for Outsourcing (Summing Components):

o Summed for each year and multiplied by Sales Quantity.

Year Sales Component Transportation Inventory Total

Quantity Cost per Unit Cost per Unit Cost per Unit Outsourcing
(5% of Cost
Material)
1 300,000 Rs. 20.00 Rs. 2.00 Rs. 0.70 Rs. 6,810,000
2 500,000 Rs. 20.00 Rs. 2.20 Rs. 0.77 Rs. 11,485,000
3 700,000 Rs. 22.20 Rs. 2.40 Rs. 0.85 Rs. 17,672,900
4 900,000 Rs. 24.20 Rs. 2.60 Rs. 0.93 Rs. 24,958,530
5 1,000,000 Rs. 26.62 Rs. 2.80 Rs. 1.02 Rs. 30,444,870
Conclusion: Based on cost comparison, outsourcing appears more economical than in-house
manufacturing for each year.

Question 2. What other factors should ABC Ltd. look at for making this decision?

Answer:

ABC Ltd. needs to consider several additional factors beyond just cost when deciding whether to
manufacture in-house or outsource production. Here’s a breakdown of these factors:

1. Quality Control

 In-house production allows the company to maintain strict control over the quality of the
valves, as production is managed directly by their team.

 Outsourcing may introduce quality variability, as the outsourced supplier may not adhere to
the same standards. This is a key concern for ABC Ltd., especially with the recent quality
complaints.

2. Flexibility and Control

 In-house production provides more flexibility in responding to changes in demand or

product specifications. The company can quickly adjust production methods or materials if
needed.

 With outsourcing, ABC Ltd. might face limitations in making sudden changes, as they would
be dependent on the supplier’s processes and timelines.

3. Supply Chain Reliability and Lead Times

 Outsourcing introduces potential risks in the supply chain, such as delays in delivery, which
could disrupt production schedules and impact customer satisfaction.

 Relying on a supplier means ABC Ltd. would be dependent on the supplier’s ability to meet
deadlines. This could become problematic, especially if demand continues to increase as
forecasted.

4. Labor and Workforce Management

 Expanding in-house production would mean ABC Ltd. needs to hire additional workers,
which may be challenging given the current workforce’s dissatisfaction with workload and
pay. Managing this issue could lead to further operational costs.

 Outsourcing reduces the need to hire and manage more workers, potentially reducing HR
management complexities and overtime costs.

5. Strategic Focus and Core Competencies

 If ABC Ltd. specializes in certain manufacturing processes, it may be beneficial to continue

producing in-house to strengthen their core competencies.

 On the other hand, outsourcing can allow ABC Ltd. to focus on other strategic aspects, such
as product development, marketing, and expansion into new markets.
6. Cost Considerations Beyond Direct Production Costs

 The initial analysis focuses on direct costs; however, indirect costs, such as long-term
equipment maintenance, additional storage space, and utility costs, should be considered in
the in-house option.

 With outsourcing, additional costs might come from transportation, contract management,
and possibly higher costs due to supplier markups.

7. Scalability

 In-house production may face scalability limits due to space constraints and hiring
challenges.

 Outsourcing could allow for more scalable production as the supplier might have the
capacity to handle the higher volumes forecasted in later years without additional
investment from ABC Ltd.

8. Financial Stability and Risk Mitigation

 Outsourcing allows the company to convert fixed costs into variable costs (e.g., production
costs per unit rather than large investments in machinery and space), which can be helpful if
the market conditions change.

 By outsourcing, ABC Ltd. may also reduce financial risk associated with the initial investment
in new machinery and the added facility costs.

Conclusion: ABC Ltd. should evaluate not only the total production costs but also these strategic and
operational factors to decide on the most sustainable approach. They may find that a hybrid
approach (partial outsourcing for certain components) balances cost with control, quality, and
flexibility.