Question

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 Square feet 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 sceptical 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 $5000 with expected increase of 10 % per year. Direct wages of worker as $4 per unit. With 10 % reduction in second year, no change in 3rd year and increase of 10 % every subsequent year. Material cost of $14 per unit with an increase of 10 % every year. Power and fuel cost of $2 per unit with increase of 10 % every year. Indirect labour as 50 % of direct labour. They will have to buy a new machine with a cost of $50 lac. With usable life of 5 years Mr Naresh explained his details as follows: Component price from supplier at $20 for the first 2 years with an increase of 10 % every subsequent year. Transportation cost of $2 per unit for the first year with increase of $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

Questions 1. Based on this data, is it economical for ABC Ltd.to go for buying the product from market or manufacturing in house.

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

Question 3. What factors of quality are important to make the final decision whether to manufacture in house or procure?

Reasonable assumptions that are not stated in the case will be accepted.

Answer 1

1. The following table gives the cost comparison of in house cost and outsourcing cost.

Manufacturing Cost:

Year	1	2	3	4	5	Total
QTY PER YEAR	300000	500000	700000	900000	1000000	3400000
MATL COST / UNIT	14	15.4	16.94	18.634	20.4974
LABOR COST / UNIT	4	3.6	3.6	3.96	4.356
INDIRECT LABOR COST / UNIT	2	1.8	1.8	1.98	2.178
POWER & FUEL COST / UNIT	2	2.2	2.42	2.662	2.9282
VARAIBLE COST / UNIT	22	23	24.76	27.236	29.9596
TOTAL VARIABLE COST / YEAR	6600000	11500000	17332000	24512400	29959600	89904000
SUPERVISOR SALARY / YEAR	60000	66000	72600	79860	87846	366306
MACHINE COST / YEAR	1000000	1000000	1000000	1000000	1000000	5000000
TOTAL COST / YEAR	7660000	12566000	18404600	25592260	31047446	95270306

Procurement Cost:

Year	1	2	3	4	5	Total
QTY PER YEAR	300000	500000	700000	900000	1000000	3400000
MATL COST / UNIT	20	20	22	24.2	26.62
TRANSPORT COST	2	2.2	2.4	2.6	2.8
INVENTORY COST	1	1	1.1	1.21	1.331
VARAIBLE COST / UNIT	23	23.2	25.5	28.01	30.751
TOTAL COST / YEAR	6900000	11600000	17850000	25209000	30751000	92310000

Considering the costs as per table above it is very clear that we should go for buying the product from outside.

2. Even if the cost would have been same for both manufacturing in house as well as cost for procurement, we would have still gone for purchasing the product from the supplier. In case cost is higher for procurement little bit as compared to manufacturing in house, it is better still to go for buying from outside as it gives better flexibility and risk is less even if the forecast is wrong and the ultimate demand turns out to be lower than forecasted demand. Generally, whether we should go for in house manufacturing or outsourcing, we have to consider following factors.

The following factors generally influence make-or-buy decisions:

a. Relative economics

b. In-house capacity currently available

c. The need for control or secrecy

d. Advantages of access to supplier knowledge and skill

e. An opportunity to maintenance a robust supplier

f. The relative risks involved

g. Capital investment versus expense for tax purposes

h. Degree of scope definition available

i. Affects uncertainty and risk

j. Overall degree of technical, cost and schedule risk

k. Type or complexity of the requirements

l. Confidentiality of the process

m. What will be the contractor's entire responsibility?

n. Urgency of the deliverables

o. Contractors' capacity to perform

p. And/or extent of subcontracting

q. How long have we got for execution?

r. Affects the pace of the work

s. Extent of price competition

t. Contractors' accounting systems

Careful evaluation of these factors is required to arrive at final decision.