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Strategic Make or Buy Decision Methodology for Achieving Competitive Advantage

Kiwon Lee*, Euiho Suh**, Daegeun Hong*** Department of Industrial and Management Engineering Pohang University of Science and Technology (POSTECH) 77 Cheongam-ro, Nam-gu, Pohang, Gyungbuk, Korea, 790-784 w0hya@postech.ac.kr*, ehsuh@postech.ac.kr**, dghong@postech.ac.kr***

Abstract Make or Buy decision is becoming increasingly important as firms are globalized with branch plants around the world. In most cases, the decision making mainly depends on the cost analysis in terms that how we can make the products cheaper. However, for gaining companys future compatibility, it is needed to consider not only cost aspect but also technology aspect and product operation ability from a company view. In this sense, previous researches mentioned importance and factors of the technological and operational aspect theoretically, but they are insufficient to apply the Make or Buy decision process in practice. Therefore, this paper describes a systematic methodology for Make or Buy decision to achieve companys competitive advantage. The proposed methodology consists of three perspectives: technological, financial, and operational perspective. A case study of Company A, home appliance manufacturer, is performed to prove the effectiveness of the proposed methodology. Keywords: Make or Buy Decision, Quality Function Deployment, Patent Portfolio Analysis, Total Cost Analysis, Optimal Production 1. Introduction Recently, companies strategically use external resources not only to reduce their expenditures but also to maximize their manufacturing efficiency. Utilizing external resources is called to be an outsourc-

ing. This helps companies to be more flexible in responding to the global competition environment. Strategic sourcing, that is, Make or Buy is becoming the main issue of the business in order to achieve competitive advantage [7, 19]. Make or Buy decision is the act of making a strategic choice between producing an item internally (in-house) or buying it externally (from an outside supplier) [5]. However, previous studies on Make or Buy mainly discussed the production cost to gain competitive price of companies [16]. In most cases, the decision making mainly depends on the cost analysis in terms that how we can make the products cheaper. When the Make or Buy is only analyzed from the production cost perspective, companies often fall into the trap of a short-term profit instead of core competence. In this sense, Welch and Nayak [19] suggested a Make or Buy decision model considering financial and technological aspects at the same time. Sislian and Satir [16] also developed a model of Make or Buy decision including finance analysis and production analysis. Previous researchers mentioned importance and factors of the technological and operational aspect theoretically, but they are insufficient to apply the Make or Buy decision process in practice. For gaining companys future compatibility, it is needed to consider not only cost aspect but also technology aspect and product operation ability from a company view [14]. Therefore, this paper describes a systematic methodology for Make or Buy decision to achieve

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companys competitive advantage. The proposed methodology consists of three perspectives: technological, financial, and operational perspective. In technological perspective, Make or Buy decision of the product is evaluated through QFD and patent portfolio analysis. In financial perspective, Make or Buy decision of the product is evaluated by Total Cost of manufacturing. In operational perspective, optimal production is considered in Make or Buy decision. Based on the results of three perspectives, guidelines of the Make or Buy decision are developed. 2. Literature review 2.1. General concept of Make or Buy decision Product manufacturing process is generally divided into two types in terms of who produces products or items: Make and Buy [17, 18]. Make is a manufacturing type that a company produces items or components of the product by using its own in-house capabilities or functions. Make originally meant the activity for manufacturing something inside of the firm. On the other hand, buy is a manufacturing type that a company entrusts some of its internal activities to outside suppliers [5]. Nowadays, firms tend to outsource their functions and activities for the purpose of cost reduction, concentration to core competency or mass production, and action for demand fluctuation [10]. Outsourcing activity has been used for keeping competitive advantage of the firm in flexible supply of products. Make or Buy decision indicates a strategic choice between internally possessing fundamental functions or services for producing products and purchasing functions or items from external providers [5]. Past Make or Buy choice was a traditional simple question in business management [3], but as previous product and service market has been shifted to the global market, Make or Buy decision making process is becoming an important issue for not only achieving firms competitive advantage but surviving in fierce competition on global environment [7, 9, 17, 19]. With the importance of Make or Buy decision making, researches on the factors to consider in Make or Buy decision are conducted in many ways. Welch and Nayak [19] emphasized the technological aspect for firms competitive advantages through importance and maturity of process technology. Maclvor et al.

[10] developed conceptual Make or Buy decision making framework based on firms core capability and cost factors. Winer et al. [20] interpreted Make or Buy issue through cost, necessity of using firms overproduction, stability of procurement, and degree of expertise process technology. Sislian and Satir [16] suggest technological position, demand fluctuation, manufacturing capability, process maturity, and outsourcing risk as factors for evaluating Make or Buy decision. When concluding Make or Buy decision, various perspectives and factors for evaluating Make or Buy have to be considered [14]. As the previous researches indicated, major factors to consider in Make or Buy decision are largely discussed in three perspectives; technological, financial, and operational perspective. Therefore, in order to support Make or Buy decision effectively and elaborately, methodology for Make or Buy decision through integrated and balanced approach with technological, financial, and operational perspectives is needed. 2.2. Make or Buy decision making in financial perspective Companies traditionally regarded manufacturing cost as the most important factor in Make or Buy decision making [2]. For this reason, initial Make or Buy decisions were dealt with economic approach mainly based on the Transaction Cost Theory, which is accounting for the actual cost of outsourcing production of products or services including transaction costs, contracting costs, coordination costs, and search costs [11, 12, 15]. Although the economic approaches are analyzed based on the long-term goal for gaining firms competitiveness in a broad perspective, many of previous researches approaches mainly focused on the problem solving in short-term view. Besides, a firms Make or Buy decision in financial perspective are analyzed by calculating manufacturing cost in terms of the cost per each item unit supplied in general. Unit cost concept has an advantage to simply expect product cost with production quantity, but it also has a disadvantage to distribute indirect cost in manufacturing product or items. That is, fixed costs which are required in manufacturing and cant follow the detail breakdowns of the total expenditure directly are not able to allocate their

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costs into the unit cost exactly. Due to the limitation of distribution of indirect cost, a firm can take wrong decision of buy, despite it has a surplus asset or capability. In this sense, Burt et al. [1] insisted that all manufacturing related costs be included in Make or Buy decision when considering financial perspective. A distinctive feature of manufacturing products or items compared to buy them is the investment of facilities or infrastructure for making them. If a firm decides to make products or items, deservedly it has to invest money to construct a factory or set up facilities for making products or items. Short-term manufacturing cost analysis cant fully reflect the effect of investment, so it leads not to compare benefits between Make and Buy. Therefore, it is necessary to consider investment cost and to conduct financial analysis in terms of long-term and total cost view. 2.3. Make or Buy decision making in the Technological and Productive perspectives In technological perspective, a company should decide Make for components and all functions related to the technologies that will be the core technologies for the future companys competitiveness based on the importance of manufacturing technology, technologys maturity, and manufacturing capability [8]. Probert [13] presented the optimal outsourcing strategic selection introduced the 3 by 3 matrix of a technological competitiveness and technological importance for the defining the company's core technologies. Welch and Nayak [19] also introduced the 3 by 9 matrix for the classification of the company's technologies in the manufacturing strategic perspective. Make or Buy decisions are made by the reflecting the technologies to 3 by 9 matrix in terms of the technical competitive advantage, technology maturity and technical importance. In the productive perspective, a company needs to find the optimal Make points for boosting the efficiency of production to the maximum considered the manufacturing capacity of a company [4]. Sislian and Satir [16] presented the methodology of Make or Buy decision making in the form of flowchart for strategic outsourcing. Make or Buy decisions are made by the volatility of demand and productive capacity of partners, targets for outsourcing in flowchart. Thus, the technological competitiveness, technological maturity and technological importance are considered for the technological perspective and the

volatility of demand and productive capacity are reflected for the productive perspective in the previous researches about Make or Buy decision making. However, there are the limitations for previous researches that only qualitative approaches are applied for decision making. Making sophisticated decision making process is needed when qualitative and quantitative approaches for decision making are balanced. Now days, In order to achieve the company's competitive advantages by improving a company's future competitiveness and maximizing the managerial flexibility and efficiency in the global unlimited competition environments, not only financial approach but also technological and productive approaches are needed for Make or Buy decision making [10, 13]. If the approaches of decision making are overly weighted toward one side, the decision making would be interrupted by the distortion of information. A company should conduct the decision making in the synthetic perspectives based on the balanced vision because Make or Buy decision making is not for the short-term responses, but for long-term planning of the future strategy for companys management policy. In other words, a new methodology which can practically imply the companys conditions considered financial, technological and productive aspects is needed for the Make or Buy decision making. 3. Methodology The suggested methodology for Make or Buy decision is shown in Figure 1. There are four stages: technological perspective, financial perspective, operational perspective, and guidelines of decision making.

Figure. 1. Make or Buy Decision Research Framework

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3.1. Step1: technological perspective 3.1.1. Analysis of Technology Importance QFD offers casual connection between customers requirements and engineering characteristics. The customer requirements are considered to be input parameters; whereas the items or processes are considered as output parameters. This application highlights the consideration of different processes and items to see which are best suited to each diverse company. By using QFD in this study, a company needs to consider the actual customer requirements and then, match the best suited processes or items. So in this study, the typical QFD processes used in various applications are customized to select key processes and items. The proposed application of 1st QFD is to examine the choices of item importance against the requirements of a product. In 2nd QFD, the choice of process importance against the key items selected in the 1st QFD is analyzed. Figure 2 represents the elements of HOQ for this application.
Item Item 1 C.R. C.R. 1 C.R. 2 C.R. 3 : : C.R. m Item Importance Item 2 Item 3 Item n

represents the trend of patent moves caused by the general patenting activity [6]. Maturity of technology is interpreted based on this general patenting activity, and the stages are classified into four stages according to the patent portfolio. Growth period is that the technology is introduced, so it increases both application and applicant in this period. Development period is the technology is on the rapid growth of R&D, and also it increases both application and applicant rapidly. Maturity period is that the technology is on the stable stage, and trend shows stagnant or decrease in application and applicant. Finally, Decline period is the technology is decrease in application and applicant due to introduction of alternative technology. In this study, technology maturity stage is classified only into growth/development period or maturity/decline period in larger concept of maturity.

Tech. Key Item Item 1 Item 3 Item n Technology Importance

Tech. 1

Tech. 2

Tech. 3

Tech. k

Key Item
Item 1 Item 3 Item n

Key Process Tech. 1 Tech. 3

Figure. 2. 1st and 2nd QFD: C.R.-Item and Item-Process Relationship Analysis 3.1.2. Analysis of Technology Maturity The basic concept of patent portfolio as a type of the patent analysis is the tool for analyzing the stages of development of a particular technology based on the patterns in patenting activity [21]. A general model for patenting activity can be established to understand maturity of the technology through the number of patent applicants and patent applications. Technology maturity of each process technology is carried out through the patent portfolio. As plotting the bubbles on the patent portfolio which consists of two axes, the number of patent applicants and patent applications, technology maturity is defined. Bubble sizes represent the number of applications, calculating the ratio of the number of applications in particular period per total number of applications and the number of applicants in particular period per total number of applicants. Figure 3

Figure 3. Patent Portfolio-Based Technology Maturity Analysis 3.1.3. Matrix of Technology Strategy
High Technology Importance Low Non-Key Technology Non-Key Technology Rising Key Technology Saturated Key Technology

Growth/Development Period

Maturity/Decline Period

Technology Maturity

Figure 4. Matrix of Technology Strategy A matrix of technology strategy consists of two axes: technology importance and technology maturity. It can assist the Make or Buy decision-making as shown in Figure 4. In this matrix, when a process technology is high in the technology importance and is located on growth/development period in the technology maturity view, it is basically decided Make. The other cases are concluded with Buy. However,

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when a process technology is high in the technology importance, even if it is located on maturity/decline period in the technology maturity, financial analysis will be additionally performed in the next step. 3.2. Step2: Financial perspective Processes assigned to Make in the matrix of technology strategy are conducted with total cost analysis and manufacturing cost analysis. This study is premised on the assumption that a company makes a production planning based on demanding forecasting of a product. 3.2.1. Manufacturing Cost Analysis The manufacturing cost is meant the cost of producing a product or item in a company during a specific period. In Make case, the manufacturing cost is added all the primary cost, for example, material cost, labor expenses, capital expenditures, etc. In Buy case, the manufacturing cost is calculated the cost of purchasing a product or item externally. Figuring out Make cost and Buy cost during a specific period through the manufacturing cost analysis assists the Make or Buy decision-making as shown in Figure 5. In this figure, Make or Buy section is decided by the primary cost characteristics such as fixed cost and variable cost, and a number of production planning. 3.2.2. Total Cost Analysis In this study, Total cost is meant that the total amount spent on a particular cost, including the price of the investment itself, plus commissions, fees, other transaction costs, and taxes. In other words, it includes the sum of fixed costs, variable costs, and semi-variable costs during a specific period. Make or Buy decision-making is performed by using investment economic feasibility with calculated total costs of Make and Buy. 3.3. Step3: Operational Perspective

In using Make mixed with Buy condition, the optimum production of Make and Buy is calculated at a specific production planning. In the Figure 5, the Make decision can reduce total cost by buying some items at the point of additional investments by the increase of production. 3.4. Step4: Guidelines of Decision Making Make or Buy decision of processes and items is suggested based on the analysis of three perspectives: technology, finance and operation. Guidelines of decision making on make or buy is presented in 3 by 3 matrix form, Make or Buy Decision Support Matrix (Figure 6). This guideline framework can support users to decide Make or Buy effectively. It consists of technological guidelines axis (rising key technology, saturated key technology, non-key technology) and financial and operational guidelines combined concept of two perspectives (advantageous for make, buy, and mixing make and buy).

Figure 6. Make or Buy Decision Support Matrix 4. Case Study Company A is global company which is setting up local corporations in various countries and producing home appliances. Company A has made strategic use of item sourcing from foreign corporations and partner companies in local area in order to reduce manufacturing cost and investment risk, and enhance flexibility of in-house production line. However, Company A performed assembly and inspection process, relatively non-value-added works, it didnt have core process in-house for growth, and worried about the situation that Company As capability itself has been declined. Thus, in order to procure its competitiveness in the future and the world, Company A is planning to reorganize the current Make or Buy formation of each process by establishing the standards

Figure 5. Total Costs of Make and Buy According to Production Quantity

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of the optimum production through the Make or Buy decision methodology in this paper. 4.1. Step1: Technological perspective in Company A 4.1.1. Analysis of Technology Importance In the analysis of technology importance of Company A case, customer requirements of As air conditioner are derived and items for consisting of the air conditioner are listed. Based on the customer requirements the items, key items are selected through the QFD. In this case study, items which can be purchased from the outside easily and are under 1% of the cumulative cost in the air conditioner such as sticky tape, bolt, nut, etc. is filtered out of this analysis. Furthermore, 2nd QFD is skipped because of the intuitive relationship between key items and their process. After analyzing technology importance in Company A case through QFD, three manufacturing processes (A, B, C) of eight (A, B, C, D, E, F, G, H) are concluded into key processes. Due to the security policy of the Company A, name of the manufacturing processes is concealed but named it process A to H. One of the key processes in this case is SMT (Surface Mount Technology), process A. SMT is a technology for constructing electronic circuits in which the components are mounted directly onto the surface of printed circuit boards. This paper introduces the case focused only on the SMT, process A. 4.1.2. Analysis of Technology Maturity In the analysis of technology maturity of Company A case, technology maturity of the eight processes is analyzed through the patent portfolio. First of all, draft of searching formula and keywords for finding SMT related patents are prepared based on the specifications of the SMT. After that, the searching formula and keywords are refined by the technology specialist in the field of Company A, and final searching formula is derived. WIPS, the patent information database, is used in this analysis and time period for classifying application year of the patents is set into 5-year. Figure 7 represents the result of the patent portfolio by analyzing based on the number of patent applications and applicants from the Korean, Japanese, USA, and Europe patents. Patent portfolio of SMT shows that both trends of the number of patent applications and applicants are increasing in the Fig-

ure 7. Thus, technology maturity of SMT is concluded that process A (SMT) is on the growth/development period.

Figure 7. Patent Portfolio of Process A (SMT) 4.2. Step2: Technological perspective in Company A Analysis in financial perspective is simulated by Microsoft Excel application. Excel-based manufacturing cost simulation program is developed in order to support Make or Buy decision to decision makers easily in practical. Besides, due to the security policy of the Company A, the result of analysis in financial perspective in this paper is shown to virtual cost data and quantity not actual data. In manufacturing cost analysis of process A (SMT), total cost for making the items manufactured through SMT, virtually named SMTpart1, SMTpart2, and SMTpart3, is analyzed. The simulation program calculates and represents the total cost both making SMTpart1, SMTpart2, and SMTpart3 and buying in determined production quantity. First of all to calculate manufacturing cost analysis in the simulation program, planned production quantity of the items for 10 years is entered into the program. The number of planned production quantity for each item is determined by demand estimation of air conditioner. After that, value of manufacturing cost factors for making or buying items is entered into the program, when the items make or buy for the number of planned production quantity. Then simulation program calculate the one-year total cost of making or buying all SMTpart1, SMTpart2, and SMTpart3 in make and buy cases. Material cost (variable cost), labor cost (semivariable cost), facility investment cost (semi-variable cost), building construction cost (fixed cost), and land rent fee (fixed cost) are set as a manufacturing cost factor when making. SMTpart1, SMTpart2, and SMTpart3. Purchase cost (variable cost) and shipping cost (variable cost) are set as a manufacturing cost

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factor when buying. The total amount of each Make and Buy cost is calculated by the simulation program, and also it shows the total cost corresponding to production quantity of Make or Buy in a graph form as shown in Figure 8. As the capacity of the SMT facility is input to 500,000 in Make case and facility reinvestment occurs, there is jumping point of total cost on the 500,000 quantity in total cost-production quantity graph.

results of the three perspectives: technological, financial, and operational. In this SMT example, basically taking Make strategy and mixed Make and Buy for some years is concluded through the analysis of technological, financial, and operational perspective. Also a Make or Buy decision making flowchart is proposed as following Figure 9. It can support decision makers to decide Make or Buy of manufacturing processes including SMT. In this case study, Company A wants to build Make or Buy guideline process in flowchart format in order to apply the methodology easier. Therefore, Make or Buy Decision Making Flowchart is presented as following Figure 9.

Figure 8. Total Cost of Make and Buy Corresponding to Production Quantity 4.3. Step3: Operational perspective in Company A In the analysis in operational perspective, optimum production quantity is founded through mixing Make and Buy case in order to increase production performance. It is applied on the excel-based simulation program connected with the result of analysis in financial perspective. In using Make mixed with Buy of SMT items, optimum production quantity is resulted from taking better choice by comparing Make and Buy total cost in total cost-production quantity graph. In this SMT example, capacity of SMT facility is 500,000, and the number of planned production quantity in 2016 and 2017 is 600,000. For making 600,000 items in 2016 and 2017, it needs to reinvest additional facility in 2016 because one facility can produce only 500,000 in this case. It means that additional facility is built only for making 100,000 items. As you see on the Figure 8, it is more beneficial that only Company A make 500,000 items and buy the other 100,000 items from the outside in 2016 and 2017. Applying this concept into whole 10 years, total cost of manufacturing SMT items is reduced. 4.4. Step4: Guidelines of decision making in Company A Make or Buy decision making guideline in Company A is suggested covered previous analysis

Figure 9. Make or Buy Decision Making Flowchart 5. Conclusion In this study, Make or Buy decision making methodology is proposed via technological, financial, and operational perspectives. To begin with, in technological perspective, a matrix of technology strategy is developed based on the technology importance and maturity, and it enables decision makers to help making decisions in technological perspective. Secondly, in financial perspective, through the manufacturing cost analysis and total cost analysis, Make or Buy decisions are supported. Thirdly, in operational perspective, optimum production quantity through mixing Make and Buy is reflected on the decision. Finally, Make or Buy decision making guideline consider-

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ing three perspectives is proposed. In order to confirm the implementation of the methodology in practical, case study of Company A is conducted. Defining key processes and items, Analyzing total cost of manufacturing cost, and optimizing production capability is conducted for helping Make or Buy decision in constructing new foreign corporation. Company A is on the pilot test to this Make or Buy decision support methodology in air conditioner case, and it is planning to be extend to all business in Company A. Proposed methodology in this study supplements the previous studys limitation of the qualitative approaches through QFD and the patent analysis which is quantitative approach in technological perspective. Through the total cost analysis in financial perspective, short- and long-term cost and investment analysis is conducted. It also approaches the Make or Buy issue to not on dichotomy but mixed Make and Buy in operational perspective. Based on the methodology, firms can get competitive advantages in the rapidly changing circumstances by defining key processes and make standard to improve production effectiveness. The study assumed that there no interrelationship among manufacturing processes. The Make or Buy guideline of particular process can be reversed due to dependency to another process. This condition can be considered in the further research by optimization method such as integer programming. References [1] Burt, D. N., Donald W. D., and Stephen L. St., World Class Supply Management: The Key to Supply Chain Management, 7th ed., McGrawHill/Irwin, 2003.. [2] Canez, L. E., Platts, K. W. and Probert, D. R., Developing a framework for make-or-buy decisions, International Journal of Operations & Production Management, Vol.20, No.11, 2000, pp.1313-1330. [3] Fill, C. and Visser, E., The outsourcing dilemma: a composite approach to the Make or Buy decision, Management Decision, Vol.38, No.1, 2000, pp.43-50. [4] Fine, C. H. and Hax, A. C., Manufacturing strategy: A methodology & an illustration, Interfaces, Vol.15, No.6, 1985, pp.28-46. [5] Kim, M. H., An Exploratory Study of Make-orBuy Decisions in Hyundai Automobile Group: An Integrated Approach, International Area Studies Review, Vol.11, No.3, 2007, pp.615-655.

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