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COST ANALYSIS FOR 'MAKE-OR-BUY' DECISIONS FOR MANUFACTURING

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International Research journal of commerce, Business and Social science(IRJCBSS)
VOL.1.No.9,pp.151-156 (ISSN 2277-9310) Dec 2012
COST ANALYSIS FOR 'MAKE-OR-BUY' DECISIONS FOR MANUFACTURING
INDUSTRIES
Katikar R S1 Asst. Professor ,Sinhgad College of Engg, Pune -411041 Maharashtra India
1
rskatikar2k@rediffmail.com
Dr Pawar M S2,Professor & Principal,B .Mane Institute of Technology,Solapur-413002Maharashtra
India,2drmspbmit@gmail.com
Abstract
The make-or-buy question has always been a concern of complex nature which represents a
fundamental dilemma faced by many companies. The cut-throat competition compels all the manufacturing
and services companies to re-evaluate their existing processes, technologies, products and services in order
to find an opportunity to positively impact the bottom line by making strategically-drawn out make-or-buy
decisions. The 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 vendor).
Outsourcing decisions are based on the difference in the cost of purchasing or buying a product or
service from an external supplier compared to the cost of producing the item or providing the service in
house.
One important aspect of cost management is determining whether to make or buy components in a
product. A complete and correct assessment of the various elements of the cost is essential to make sound
economic decisions. In this paper an attempt is made to the determination of cost to make the item and cost
to buy it with a case study. In this paper a total cost approach method is used for finding the cost of one part
in a valve product for taking the decision about a part either to make or buy .This method helps the
manager for taking the decision about a part in a product to make in house or outsource before going to
manufacturing.
Keywords: Make or buy, outsourcing, procurement, cost analysis.
1. Introduction
No firm can manufacture each-and every item of its product. It is neither possible nor desirable.
Items which do not form the company's product line are always purchased from outside. There are different
materials used for manufacturing of items in a product which requires a different manufacturing process.
A daily question faced by managers is whether the right components and services will be available
at the right time to ensure that production can occur. Additionally, the inputs must be of the appropriate
quality and obtainable at a reasonable price.
Traditionally, the make option tended to be favored by many large firms, resulting in backward
integration and ownership of a large range of manufacturing and assembly facilities. Major purchases were
mainly confined to raw materials and components which were than processed in house. But the increased
global competition in recent years created pressures to reduce costs, downsizing the workforce and
focusing on the form’s core competencies. Hence the trend is now toward outsourcing for goods or services
that had been previously provided in house .This outsourcing decision (make-or-buy decision) is made only
after an analysis that compares internal production and opportunity costs with purchase cost and assesses
the best uses of available facilities. Consideration of an in-source (make) option implies that the industry
has available capacity for that purpose or has considered the cost of obtaining the necessary capacity.
Relevant information for this type of decision includes both quantitative and qualitative factors.
Usually, organizations compare the standard cost as determined by cost accounting with the price
a supplier is quoting in making a make/buy decision. This is almost always fallacious. The standard cost
includes fixed costs that will continue to be part of operations whether the product is manufactured in-
house or not. In many cases, the supplier’s cost will be lower than the in-house standard cost; however, the
reality is that overall industry costs and the costs of other products will increase if this part is outsourced;
this is because fixed costs will be spread over a smaller number of units after a part is outsourced. The
exception to this would be if a company shut down a portion of its operations (reduced fixed costs) and
considered outsourcing an entire manufacturing operation; in this case, it could eliminate a portion of its
fixed cost and possibly have a lower product cost. Detailed cost analysis would need to be performed to
determine whether a part is to be make in-house or buy form outside.
The remainder of the paper is organized as follows. A review on make or buy decision, as it relates
to cost and outsourcing will be given in the section 2. Followed by Factor Influencing Make-or-buy
decisions will be given in section 3. Cost analysis and economic model for make-or-buy decisions is

1
explained in Section 4, In Section 5 case study will be illustrated. Finally, concluding remarks will be given
in Section 6

2. Literature review
We reviewed the pertinent studies that discussed on the make or buy decision, as it relate to
production cost and outsourcing. Henrik Brandes et al. (1997) argued that three kinds of reasons for
decision considering outsourcing, cost efficiency, financial problem and core competence. They indicated,
especially, a combination of focus on cost efficiency reasons and core competences tends to lead a greatest
probability of success. In cost perspective, Mabin and Balderstone (2000) introduced the CPCM
(Contribution per Constraint Minute) method of make or buy analysis, which makes the decision using the
traditional costing method to decide whether to make or buy. They showed that the standard cost method
for making the outsourcing decision was inferior to the CPCM approach, which follows the TOC (Theory
of Constraints) principle (Jaydeep Balakrishnan and Chun Hung Cheng, 2005).
Edward and Geoffrey (2002) developed an engineering-based model of outsourcing, and showed
relations between optimal outsourcing fraction and cost structures, as well as technological change. In
addition, there were lots of researches for option of outsourcing it had been approached from the cost
viewpoint. Balakrishnan(1994)\cite{balakrishnan} investigated make or buy decision that compared the
cost of administering transactions inside a firm and across markets.
To decide make or buy, Lynn and James (2002) studied from cost system approach. They
analyzed cost accounting systems, such as ABC (Activity-based costing), DC (Direct costing), TCA
(Traditional cost accounting) and TOC (Theory of constraints), and showed significant differences between
the solutions obtained using the TOC/LP and other three accounting system. The cost of every minute
worked at any resource (minute rate) and the subsequent outsourced quantity and net profit can be
computed using the computational procedure suggested by Mishra et al (2007). Souren et al(2005) assessed
the quality of the TOC based approach to generate good or even optimal solutions. Varying results were
obtained when compared with other product-mix decision tools considering various product-mix situations
such as type and number of constraints, requirement of integer or non-integer solution, costs involved and
nature of objective function. Coman A.and Ronen B (2000), Chakrabarty ea tl(2006), Ray A ea
tl(2007)studied the performance measurement aspect of TOC with standard cost accounting .
In this paper we formulate an economical make or buy decision model which will help for taking
the decision about a part to be make or buy outside on based on detail cost analysis of a parting a product.
3. Factor Influencing Make-or-buy decisions
The following factors generally influence make-or-buy decisions:
(a) Cost analysis: Cost analysis refers to the determination of cost to make an item as well as cost to buy it.
The cost to make an item should include the estimated cost of raw materials, direct labour, depreciation,
interest on investment; insurance and property taxes, incremental administrative overheads; Incremental
fixed cost (procurement or setup cost) and carrying cost of raw materials and work-in-progress. The cost to
buy an item should include purchase- price of part, transportation cost, octroi and sales tax, incremental
procurement cost and carrying cost etc.
(b) Capacity Available:- If firm has available capacity in equipments, necessary skills and time it makes
sense to produce items in-house otherwise go for outsource.
(c)Expertise/Skill: - If the need experience is lacking in the firm, buying might be better alternative.
(d)Quality consideration: - Outside suppliers who specialize can usually offer higher quality products
than what the firm can produce. But unique quality requirement or the desire to closely monitor the quality
may cause a firm to decide to make.
(e)The nature of Demands: - When the demand for a product is high and stable. It is better for the firm to
produce the item rather than buy. Alternatively, when fluctuation in demand or small orders have to be
handled, it is better to buy the item from multiple sources who are specialists.
(f) Utilizations of External capabilities: Exploit external sources, learn from outsiders and increase
product diversity etc .Access outside sources’ competence or technology advantages difficult or costly to
attain in-house
4. Cost analysis and Economical model for make-or-buy decision.
Cost analysis refers to the determination of cost to make the item and cost to buy it. A complete and
correct assessment of the various elements of the cost is essential to make sound economic decisions. The
analysis is based on annual requirements of components against the following elements;
a) Raw material: The raw material cost consists of cost raw materials less value recovered due to the sale

2
 of scrap . The raw material cost is considered towards the cost to make. However, if the raw material is
supplied to the vendor free of cost, the cost of such materials also requires to be added to the cost to
purchase.
b)Labour cost: Labour cost implies the wages and costs of other benefits payable to the workmen engaged
on the job.
c) Tooling cost: Jigs and fixtures generally require to be made if the item is to be machined in-house. The
Jigs and fixtures once made maintain their accuracy only for certain quantity, say "n" pieces, after which
again a new set of jigs and fixtures require to be made. The cost of tooling thus requires to be amortized
over “n" pieces and the annual cost of such tooling require adding to the "cost to make".
At times, when an item is purchased from outside vendors, certain special cutting tools and jigs and
fixtures require to be supplied to the vendor free of cost. The cost of such tooling therefore requires to be
considered separately as tooling cost towards "cost-to-buy".
d) Overhead cost: Overhead cost includes indirect material cost, indirect labour cost, indirect expenses .In a
manufacturing industries over head cost can broadly be divided into three category: (i) factory or works
where production is done,(ii)office and administration ,where routine as well as policy matters are decided:
and (iii) selling and distribution where products are sold and finally to the customer.
e) Set -up Cost: Set-up cost is the "preparation cost" of the machines and it varies depending upon the
number of production runs in a year .
f) Procurement cost: The procurement cost is the cost of raising a purchase order and processing the
deliveries from the vendor(s) and it varies depending upon the frequency of receipts of the item from' the
vendors(s).
g) Purchase cost: Purchase cost includes the price given to the vendor, packing and forwarding; excise, sales
tax, transport cost, octroi, etc.
h) Capacity cost: Capacity cost implies the cost of capacity rendered idle if the number of items currently
being manufactured are purchased; Such a cost requires to be 'added to the "cost to buy" for making a
comparison of make or buy decision..
Following figure No.1 shows the economic model for taking the decision about a part to make
inhouse or buy outside on the basis of total cost approach.

Fig.no1.Economic model for make or buy decision

5. Case study on make-or-buy decisions
This case study is based on a detailed study conducted at a medium size valve manufacturing company ,
located at Chakan in Pune district (Maharashtra)in -the area of make-or-buy decisions. The study was
conducted, with an object to evaluate and justify whether a adaptor part of a 6”#150 tunion plate valve
actuator is to be make or outsource based on total cost approach .Following table no.1 shows the operation
performed ,machine used, cycle time, setup time, batch quantity, total time for machining a adaptor part. In
company there are total nine different machines to machine the different parts of valve .the machine are

3
used for a machining adaptor and other details are given in table no.2 for cost analysis. Operators rate
monthly [(Rs.9000/26(days)/7(hrs))= Rs.49/hr].

Table No.1.Data for operation and time for a part

Part Name Operation Machine cycle time Setup time Batch Qty Total Time
Turning CNC Turning DX 200 33.5 60 100 34.1
Drilling VMC1000 40 80 100 40.8
Adapter
Milling HMC500 44 40 100 44.4
Boring HBM-China 20 120 100 21.2

VMC1000 HMC500 CNC Turning DX 200 HBM-China

Machine basic Cost 3000000 5700000 1552200 9000000
Area required Sq.ft 400 500 150 700
Interest rate in % 16 16 16 16
Depreciation rate in % 10.3 10.3 10.3 10.3
Machine life 10 years 10 years 10 years 10 years
Rent in Rs. per Sq. Foot 16 16 16 16
Tooling Cost(Avg) 12 60 18 60
Consumable(Avg) 4 4 4 4
Rent/ hr 13 16 5 22
Energy Charges/hr 40 25 25 100
Depreciation/hr 48 91 25 112
Interest/hr 80 152 41 240
Maintenance/hr 10 10 10 10
Total 207 358 129 549
Overhead Contribution of M/c
cost to total cost of all M/c 6% 12% 3% 19%
Over heads In Rs/hr 11 22 6 34

Overhead structure For in house manufacturing

Position No. of position salary monthly(Rs) Total salary(Rs)
Manager 1 40000 40000
Shop In-charge 1 22000 22000
Supervisor 2 17000 34000
Helper 3 6000 18000
Total 96000
A similar cost analysis calculation has been done for collecting a data from vendor as given table no.2 .
Table no.2 for cost comparison between inhouse manufacturing and form outside.
Cost element Make in-house outsource
Raw material cost 1242.00 1242.00
Labour cost(Total time X Rs/hr/pc) 115.00 89.00
Tooling cost(on machine) 82.00 92.00
Overheads
i)indirect labour(∑(time on each m/c X over head rate) 39.00 23.00
ii)Depreciation of M/c used(∑(time on each m/c X depreciation rate) 154.00 170.00
iii)interest(∑(time on each m/c X interest rate/hr) 275.00 294.00
iv)cost of space used by m/c(∑(time on each m/c X rent/hr) 43.00 50.00
Variables over heads
i)Consumables 9.00 6.00
ii)Electric charges(∑(time on each m/c X Energy Charges/hr) 92.00 118.00
iii)Maintenance 23.00 26.00
Purchase cost(Admin OH+Selling OH+Profit) 217.00
2063 2327
The part taken for case study was outsource at Rs.2327/Pc. When the detailed in-house cost analysis was
carried out it can be seen From Table no.2 the cost of manufacturing in-house in less than outside hence
industry should go for in-house manufacturing.

4
 6.Conclusion
In this study a economic model has been constructed, which helps to the manager to take a
decision about a part in a product, when industry introduces new products, experiences increase in demand
of existing products, adjudges performance of its existing vendors unsatisfactory or finds the cost of present
practice of buying / manufacturing apparently high .A total cost methodology has been used for calculating
cost of a part in a product and described at a length. The proposed methodology is validated by taking an
example of valve manufacturing company.
References
1.Balakrishnan, S., 1994.,” The dynamics of make-or-buy decisions”, European Journal of Operational Research,
vol.74,pp. 552-571.
2. Chakrabarty P.S,.Majumdar G,.Sarkar B, 2006 “Constraint Resource Management and Production Related Decision-
A Case study”, International Journal of Production Research, vol-86, pp-48-53
3. Coman, A. and Ronen, B., 2000,” Production outsourcing: a linear programming model for the theory of
constraints”, International Journal of Production Research, vol.38, pp.1631-1639
4. Edward.G.Anderson,Jr, Geoffrey.G.Parker, 2002.” The effect of learning on the make/buy Decision”, Production
and Operations Management Society, vol.11,no.3.pp.22-26
5.Henrik Brandes, Johan Lilliecreutz and Staffan Brege, 1997.” Outsourcing-success or failure?: Findings from five
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