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Make-or-buy decisions usually arise when a firm that has developed a product or part—or
significantly modified a product or part—is having trouble with current suppliers, or has
diminishing capacity or changing demand.
The increased existence of firms that utilize the concept of lean manufacturing has prompted an
increase in outsourcing. Manufacturers are tending to purchase subassemblies rather than piece
parts, and are outsourcing activities ranging from logistics to administrative services. In their
2003 book World Class Supply Management, David Burt, Donald Dobler, and Stephen Starling
present a rule of thumb for out-sourcing. It prescribes that a firm outsource all items that do not
fit one of the following three categories:
(1) the item is critical to the success of the product, including customer perception of important
product attributes;
(2) the item requires specialized design and manufacturing skills or equipment, and the number
of capable and reliable suppliers is extremely limited;
and
(3) the item fits well within the firm's core competencies, or within those the firm must develop
to fulfill future plans. Items that fit under one of these three categories are considered strategic in
nature and should be produced internally if at all possible.
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
• 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
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:
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.
While cost is seldom the only criterion used in a make-or-buy decision, simple break-even
analysis can be an effective way to quickly surmise the cost implications within a decision.
Suppose that a firm can purchase equipment for in-house use for $250,000 and produce the
needed parts for $10 each. Alternatively, a supplier could produce and ship the part for $15 each.
Ignoring the cost of negotiating a contract with the supplier, the simple break-even point could
easily be computed:
$250,000 + $10Q = $15Q
$250,000 = $15Q − $10Q
$250,000 = $5Q
50,000 = Q
Therefore, it would be more cost effective for a firm to buy the part if demand is less than 50,000
units, and make the part if demand exceeds 50,000 units. However, if the firm had enough idle
capacity to produce the parts, the fixed cost of $250,000 would not be incurred (meaning it is not
an incremental cost), making the prospect of making the part too cost efficient to ignore.
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.
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.
R. Anthony Inman
FURTHER READING:
Balakrishnan, Jaydeep, and Chun Hung Cheng. "The Theory of Constraints and the Make-or-
Buy Decision: An Update and Review." Journal of Supply Chain Management: A Global Review
of Purchasing & Supply 41, no. 1 (2005): 40–47.
Burt, David N., Donald W. Dobler, and Stephen L. Starling. World Class Supply Management:
The Key to Supply Chain Management. 7th ed. Boston: McGraw-Hill/Irwin, 2003.
Gardiner, Stanley C., and John H. Blackstone, Jr. "The 'Theory of Constraints' and the Make-or-
Buy Decision." International Journal of Purchasing & Materials Management 27, no. 3 (1991):
38–43.
Wisner, Joel D., G. Keong Leong, and Keah-Choon Tan. Principles of Supply Chain
Management: A Balanced Approach. Mason, OH: Thomson South-Western, 2005.