What are the type of decisions about whether a firm should make or buy the component parts that go into the final product known as?

Starting a business does not necessarily mean that you have to manufacture all of your products yourself. There are plenty of third-party suppliers who can provide certain items to you, allowing you to save time and money.

The decision as to whether to make vs. buy a product is based on a variety of factors, including the cost of either option, whether the product is available from other vendors, the expertise and resources your business has when it comes to manufacturing, and whether you have enough cash in place to make a purchase.

If you’re starting a new product-based business, you face some important decisions. One is whether to make vs buy the products you’re going to sell. To decide, businesses conduct a make-or-buy analysis, which helps them determine which approach is the most cost-effective for the products they’re going to sell.

A make-or-buy analysis should weigh some or all of the following, as well as any other factors unique to your specific business:

• Cost: All other things considered, this will often be the one deciding factor. You’ll want to get accurate estimates in order to pin down the costs to make vs. buy your items.
• Availability: The truth is, in many instances, you won’t have the option to buy the item. If you’re selling something unique or what you buy would require a manufacturer to do so customization that it’s cost prohibitive, the decision will tip in favor of making your own products.
• Expertise: You may have a great product you want to sell, but someone else has the expertise to put it together. If you spend months attempting and ultimately failing at creating the product yourself, you’ll lose any money you might have saved by just buying it.
• Resources: If you don’t already have access to the people, facilities and equipment necessary to make your products, you’ll need to factor in the costs of adding those resources versus purchasing the items from a company that already has these things in place.
• Available cash: The truth is, making a large up-front purchase costs money. It’s important to make sure you have or can get the capital necessary to buy the products. If you can put together 100 items a week in your home office, you may be able to start collecting orders and sell enough to put money aside to add employees and buy factory space as your business grows.

Often, the decision to make your products comes naturally, based on the product your business is selling. If, for instance, you’ve invented an item that doesn’t exist anywhere else, you’ll have no choice but to make it yourself. This is one of the biggest benefits of the make strategy – you can create a product that can’t be bought anywhere else.

Another benefits to the make strategy is that you’ll be able to expose everyone in your organization to the details of producing your product, from start to finish. This is a benefit you wouldn’t have if a third party made the items, especially if your team never even gets to tour the manufacturing facilities.

You also won’t have to worry about scheduling or your suppliers falling through on their end of the deal. You’re more in control of everything, so you’ll know early on if you won’t be able to fulfill the current orders on time. You’ll also have an ongoing understanding of whether you’ll be able to sustain your current production and when you may need to scale resources to keep up.

One of the biggest advantages of the buy strategy is being able to find a manufacturer that has expertise in a particular type of product. This manufacturer may even have been creating these products for years, allowing for all of the bugs to be worked out in the early days. You’ll also benefit from the facility and employees the manufacturer already has in place, which will give you the advantage of having those resources without having to pay ongoing costs for them.

As you’re creating your make-or-buy analysis, it’s important to crunch the numbers both ways. Don’t assume it’s always more expensive per item to purchase it rather than make it. You may find that by buying in bulk, you can get a lower cost per unit than you could achieve on your own, when the cost of materials and labor are factored in.

Before you finalize your make-or-buy decision, you’ll need to get out your calculator and do a little number crunching. It isn’t enough to look at the cost to manufacture versus the cost to buy. You’ll need to see, long-term, just how much either option will cost.

One of the best ways to do this is through a break-even analysis. This is done using a simple formula: Break-Even Point (Units) = Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit). So you’ll determine the fixed cost for the item, then divide that figure from the revenue per unit, less the variable cost per unit. That will give you your break-even point.

Using this formula, you would do a make-or-buy analysis and add up all fixed costs to manufacture the item. Those are the costs that will not change, such as the fixed wages you pay. You’ll also determine the revenue for each item produced and the variable cost per unit, which are the expenses that can change, such as the cost of parts. This tells you how many units you’ll need to manufacture to break even on those costs.

Although you’ll need capital to purchase products to get your business started, you’ll also need money to make your items. First, there are the costs to purchase and store your parts, materials and products until they’re sold. If you can rent this space at a set fee, this will be one of your fixed costs. You’ll also have to pay anyone who will help with making the items, as well as the equipment you’ll need to get started.

Variable costs include the money you’ll spend on parts and materials. Even if you’re making an item that has never been made before, the fabric, plastics, hardware and other materials that will make it up are already in existence. Chances are, your cost of those items will vary from one month to another, especially if your customer demand fluctuates.

If you choose to go with purchasing after doing your make or buy analysis, the next move is to find a good vendor. Hopefully by now you know exactly what product or products you’re going to sell. You’ll want to look through different vendors’ inventories to compare quality and prices.

Being flexible during this process helps. If you’re very specific about what you want, though, you’ll need to search for manufacturers who makes exactly what you have in mind or find out if they can modify their products to fit your needs.

You can usually save money by going overseas, but this will require you to deal with the cost and time related to having the products shipped internationally to you. You also may not have the control you’d have if they were made nearby.

One of the most common outsourcing scenarios is one in which a company must decide whether it is going to make a component that it needs in manufacturing a product or buy that component already made. For example, all of the components of the iPhone are made by companies other than Apple. Ford buys truck and automobile seats, as well as many other components and individual parts, from various suppliers and then assembles them at Ford factories. With each component, Ford must decide if it is more cost effective to make that component internally or to buy that component from an external supplier.

This type of analysis is also relevant to the service industry; for example, ADP provides payroll and data processing services to over 650,000 companies worldwide. Or a law firm may decide to hire certain research activities to be completed by outside experts rather than hire the necessary staff to keep that function in-house. These are all examples of outsourcing. Outsourcing is the act of using another company to provide goods or services that your company requires.

Many companies outsource some of their work, but why? Consider this scenario: Today, while driving home from class, one of your car’s engine warning lights goes on. You will most likely take your car to an auto repair specialist to have it analyzed and repaired, whereas your grandfather might have popped the hood, grabbed his toolbox, and attempted to diagnose and fix the problem himself. Why? It is often a matter of expertise and sometimes simply a matter of cost benefit. In your grandfather’s time, car engines were more mechanical and less electronic, which made learning to repair cars a simpler process that required less expertise and only basic tools. Today, your car has many electronic components and often requires sophisticated monitors to assess the problem and may involve the replacement of computer chips or electronic sensors. Thus, you opt to outsource the repair of your car to someone who has the knowledge and facilities to provide the repair more cost effectively than you could if you did it yourself. Your grandfather likely could have made the repair to his car several decades ago as cheaply as the mechanic with only a sacrifice of his time. To your grandfather, the cost of his time was worth the benefit of completing the repair himself.

Companies outsource for the same reasons. Many companies have found that it is more cost effective to outsource certain activities, such as payroll, data storage, and web design and hosting. It is more efficient to pay an outside expert than to hire the appropriate staff to keep a particular task inside the company.

Thermal Mugs, Inc., manufactures various types of leak-proof personal drink carriers. Thermal’s T6 container, its most insulated carrier, maintains the temperature of the liquid inside for 6 hours. Thermal has designed a new lid for the T6 carrier that allows for easier drinking and pouring. The cost to produce the new lid is $2.19:

Plato Plastics has approached Thermal and offered to produce the 120,000 lids Thermal will require for current production levels of the T6 carrier, at a unit price of $1.75 each. Is this a good deal? Should Thermal buy the lids from Plato rather than produce them themselves? Initially, the $1.75 presented by Plato seems like a much better price than the $2.19 that it would cost Thermal to produce the lids. However, more information about the relevant costs is necessary to determine whether the offer by Plato is the better offer. Remember that all the variable costs of producing the lid will only exist if the lid is produced by Thermal, thus the variable costs (direct materials, direct labor, and variable overhead) are all relevant costs that will differ between the alternatives.

What about the fixed costs? Assume all the fixed costs are not tied directly to the production of the lid and therefore will still exist even if the lid is purchased externally from Plato. This means the fixed costs of $0.51 per unit are unavoidable and therefore are not relevant.

Calculations show that when the relevant costs are compared between the two alternatives, it is more cost effective for Thermal to produce the 120,000 units of the T6 lid internally than to purchase it from Plato.

By producing the T6 lid internally, Thermal can save $8,400 ($210,000 − $201,600). How would the analysis change if a portion of the fixed costs were avoidable? Suppose that, of the $0.51 in fixed costs per unit of the T6 lid, $0.12 of those fixed costs are associated with interest costs and insurance expenses and thus would be avoidable if the T6 lid is purchased externally rather than produced internally. How does that change the analysis?

In this scenario, it is more cost effective for Thermal to buy the T6 lid from Plato, as Thermal would save $6,000 ($216,000 − $210,000).

The difference in these two presentations of the data emphasizes the importance of defining which costs are relevant, as improper cost identification can lead to bad decisions.

These analyses only considered the quantitative factors in a make-versus-buy decision, but there are qualitative factors to consider as well, including:

• Will the T6 lid made by Plato meet the quality requirements of Thermal?
• Will Plato continue to produce the T6 lid at the $1.75 price, or is this a teaser rate to obtain the business, with the plan for the rate to go up in the future?
• Can Plato continue to produce the quantity of the lids desired? If more or fewer are needed from Plato, is the adjusted production level obtainable, and does it affect the cost?
• Does using Plato to produce the lids displace Thermal workers or hamper morale?
• Does using Plato to produce the lids affect the reputation of Thermal?

In addition, if the decision is to buy the lid, Thermal is dependent on Plato for quality, timely delivery, and cost control. If Plato fails to deliver the lids on time, this can negatively affect Thermal’s production and sales. If the lids are of poor quality, returns, replacements, and the damage to Thermal’s reputation can be significant. Without long-term agreements on price increases, Plato can increase the price they charge Thermal, thus making the entire drink container more expensive and less profitable. However, buying the lid likely means that Thermal has excess production capacity that can now be applied to making other products. If Thermal chooses to make the lid, this consumes some of the productive capacity and may affect the relationship Thermal has with the outside supplier if that supplier is already working with Thermal on other products.

Make versus buy, one of many outsourcing decisions, should involve assessing all relevant costs in conjunction with the qualitative issues that affect the decision or arise because of the choice. Although it may appear that these types of outsourcing decisions are difficult to resolve, companies throughout the world make these decisions daily as part of the company’s strategic plan, and therefore, each company must weigh the advantages and disadvantages of outsourcing production of goods and services. Some examples are shown in Table 10.2.

Advantages and Disadvantages of Outsourcing

Advantages of Outsourcing	Disadvantages of Outsourcing
Utilizes external expertise, removes the need for in-house expertise Frees up capacity for other uses Frees up capital for other uses Allows management to focus on competitive strengths Transfers some production and technological risks to supplier	Takes away control over quality and timing of production May limit ability to upsize or downsize production May have hidden costs and/or a lack of stability of price May diminish innovation Often makes it difficult to bring the production back in-house once it has been removed

Table 10.2

In an outsourcing decision, the relevant costs and qualitative issues should be analyzed thoroughly. If there are no qualitative issues that affect the decision and the leasing or purchasing price is less than the relevant (avoidable) costs of producing the good or service in house, the company should outsource the product or service. The following example demonstrates this issue for a service entity.

Lake Law has ten lawyers on staff who handle workers’ compensation and workplace discrimination lawsuits. Lake has an excellent success rate and frequently wins large settlements for their clients. Because of the size of their settlements, many clients are interested in establishing trusts to manage the investing and distribution of the funds. Lake Law does not have a trust or estate lawyer on staff and is debating between hiring one or using an attorney at a nearby law firm that specializes in wills, trusts, and estates to handle the trusts of Lake’s clients. Hiring a new attorney would require $120,000 in salary for the attorney, an additional 20% in benefits, a legal assistant for the new attorney for 20 hours per week at a cost of $20 per hour, and conversion of a storage room into an office. Lake spent $100,000 on redecorating the offices last year and has sufficient furniture for a new office. The attorney at the nearby firm would charge a retainer of $50,000 plus $200 per hour worked on each trust. The retainer is in addition to the $200 per hour charge for work on trusts. The average trust takes 10 hours to complete and Lake estimates approximately 50 trusts per year. In addition, an external attorney would charge $500 for each trust to cover office expenses and filing fees. Which option should Lake choose?

To determine the solution, first, find the relevant costs for hiring internally and for using an external attorney.

Based on the quantitative analysis, Lake should hire an estate attorney to have on staff. For the year, the firm would save $10,200 ($164,800 for internal versus $175,000 with the external attorney) by going with the internal hire. Other potential advantages would be that an in-house attorney could complete more than the estimated 50 trusts without incurring additional costs, and by keeping the work in-house, it helps to build the relationship between the firm and the clients. A disadvantage would be if there is not sufficient work to keep the in-house attorney busy, the company would still have to pay the $120,000 salary plus the additional costs of $44,800 for benefits and the legal assistant’s salary, even if the attorney is working at less than full capacity.

The iPhone is the ultimate example of outsourcing. Though created in the United States, it is produced all around the globe, with thousands of parts supplied by over 200 suppliers—none of which is Apple. Read this article from The New York Times on where parts for the iPhone are made to learn how an iPhone gets from the design phase in the United States to production of components around the world, to assembly in China, and then back to the United States for sale in a retail store.