Make or Buy?

Developed by Mehmet Kalköseler

Abstract

There has always been a dilemma for the companies regards to either making the product in-house facility or buying the necessary products from the suppliers. Production costs, extra labor costs, monitoring costs, storage requirement costs, waste product disposal costs should be considered in-house production. On the other hand, product purchase price, sales tax charge, shipping costs, inventory holding costs, ordering costs should be considered while buying the products from the suppliers .

The decision is crucial for the companies regards to time and profit. Therefore, all the constraints and requirements should be analyzed step by step, then the decision can be given regards to ease and profit. The decision process can be divided into 4 stages such as planning, evaluation, analyzing, and selecting . After the decision has been made, there are different types of contracts that should be preferred and negotiated with the suppliers.

In this article, I will slightly introduce the importance of the make and buy decisions included with crucial points that need to be considered for the company and then the focus will be explaining the 4 steps regarding to make or buy decisions. Different types of contracts such as fixed-price contracts, cost-reimbursement contracts, and time and material contracts with the suppliers are also going to be examined at the end of the article.

Make or Buy Decision Process

Figure 1: 4 stages in the make or buy decision process .

Make or buy decisions are crucial for the companies; not only for increasing profit and decreasing the time of the process but also it affects operations within the company. Therefore, there have been lots of research regarding the make or buy decisions through last years. However, there is no true answer that can be implemented for all the decisions or there is no formula to obtain the result of the decision by mathematically. It is managerial level strategical decision to be made which has both cons and pros either choosing in-house production or outsourcing from the suppliers. There are different aspects that should be considered while making the strategical decision such as company might having problems with suppliers, problems with capacity, initial investment priorities or expecting change in demands in the future market.

According to Bajec and Jakomin, it is suggested that make or buy decision should be examined in 4 steps which are planning stage, evaluation stage, analyzing stage, and selecting stage .

It is also suggested that similarly on “Should we make or buy” article by Serano, Ramirez and Gasco, divided into 4 phases included planning (setting objectives and required resources), data collection and analysis (ranking the attribute generation, attribute weighting, attribute rating), performance evaluation and improvement.

Planning stage

In this stage, the first step is to select the planning team, team leader and outsourcing consultant. The team should be included from mid-level managers to help the senior managers with heavy work they have while there should also be technical knowledgeable employees within the team. It is suggested that the importance of outsourcing might be viable for the company instead of in-house production should be explained detailly to employees to prevent the risks of having negative thoughts from the employees. There is also need for an independent consultant who can have wider opinion and experiences regarding to the similar projects they had before. Therefore, they might be helpful to avoid mistakes and can show their expertise while giving advice for the project.

Evaluation stage

After building the team and the team leader, it is vital to understand the company’s vision and strategies regarding to outsourcing and how will the decision affect the company in long term. After understanding mission and vision, it is suggested that to set the objectives and motives since different decisions can be seem useful without having the proper goals to achieve. “The objectives for outsourcing are often derived directly from the motives for outsourcing that can be grouped into a few summarized categories: concentration on core business, investment reduction, restructuring of the supply chain, cost reduction and service improvements” .

Analyzing stage

The purpose of this stage is to make an assessment regarding to cost of the in-house production and outsourcing from the suppliers by considering all the expenses that will be made both in long term and short term such as costs of making in-house production; production costs, extra labor costs, training the employees, salaries, monitoring costs, storage requirement costs, waste product disposal costs, and costs of outsourcing; product purchase price, sales tax charge, shipping costs, inventory holding costs, ordering costs . All the costs should be taken into account especially those are hard to see by forecasting to be able to make a proper cost and benefit analysis. And it is important to examine the current procedure to observe the current flows and future improvements.

Selecting stage

After consideration of the vision and mission of the company and gathering all the data regarding the costs of the in-housing and outsourcing applications with the forecasting the future costs, strategical decision can be made by the managerial level. It can be either in-house production or outsourcing which have different benefits for the companies or some parts of the product can also be bought from the suppliers while others made in-house production. After the make or buy decision has been made, it is time for selecting the right service providers. In order to identify the qualified providers, the company should implement; “open a dialogue with outside organizations the company is already doing business with, use the organization’s professional network, direct research, use consultants” .

Decision Phase

Choosing the either buying from outsource or making in-house production have both different advantages. Either “outsourcing locally where firms can have a higher degree of control and a better relationship with the external provider or insourcing the product or service through the development of an automated manufacturing process or a smart factory” which they both can be seen to have different level of benefits to the company besides the profit.

If the decision is buying from the outsource suppliers, further research will be needed to choose between the suppliers which is more convenient for the company either profit or process time. There are also some other important parts while choosing suppliers such as quality and reliability, speed and flexibility, strong service and clear communication, and financial security of the supplier . After choosing the right suppliers within the company needs, it is time for the negotiation with the suppliers. Before starting negotiation with the supplier that company has decided, there are some key elements that need to be clarified such as price, delivery schedule and payment terms. After reaching an oral agreement with the suppliers, there are different types of contracts that should be considered according to company needs.

Contracts with Suppliers

Contracts play an important role for both buyers and suppliers to provide legal protection in the transaction. It defines the rights and responsibilities for both buyers and suppliers and set a limitation or give a write to terminate the contract after failing their duties either on payment or delivering the products. There are there most common contracts; Fixed-price contracts, cost-plus contracts, and time and materials contracts .

Fixed-price contracts

In this type of contracts, the buyer makes a descriptive plan including the timeframes, the number of units needs to be delivered, quality of the products etc. After seller use the information provided by the buyer, they create a formal statement with mentioning “the project cost, including all labor and materials, along with the billing milestones based on a detailed project schedule” . There are some benefits for the buyers in this type of contracts such as knowing that how much money would it cost from the beginning and paying the money when each milestone delivered. The only risk for the buyer might be paying all the money for the contract at the beginning of the work which may result having troubles to get back the payments if sellers have troubles fulfil their obligations.

Cost-reimbursement contracts

In this type of contracts, sellers charge the buyers with a fixed percentage together with cost of the delivered products. “Sellers charge the buyers for the actual cost of any materials, equipment, labor, and overhead involved in running the project. To make a profit, sellers tack on an extra fee based on the terms of the contract. Some sellers prefer an incentive payment option over a fixed percentage” . It is also clearly shown the maximum amount can be spent by sellers in the contracts. There are some benefits for the buyers such as they only pay for the delivered products with no initial payments. The risks for buyers are not knowing the costs of the project from the start and the costs of the delivered products may fluctuate over time because of the costs of materials are used may change.

Time and Materials contracts

In this type of contracts, buyers have been charged for the materials’ cost and time needed to spend on the project by the sellers. It is good contracts for the sellers who are unsure about how long will project last and how much cost of materials will be and it is also good contracts for buyers who are unsure about the expectation of outcome of the project. “When sellers charge buyers based on time and materials, they typically keep a record of the time spent working on a certain project, as well as proof of any work they did during this time. This provides buyers peace of mind that their money is well spent” . The only risk for the buyers if they can’t manage the project well or keep track on the time spent by sellers, it can be overpriced for buyers.

Conclusion

Make or buy decisions are the important for companies not only for the profit or time efficiency but also, they are affecting the vision and mission of the company such as spending less time on the things they are not supposed to focus on might give the company freedom and expand their vision. And there are lots of parameters regarding to this decision. Therefore, it is good to examine the decision process divided into 4 categories: planning stage, evaluation stage, analyzing stage, and selecting stage . After covering all the steps carefully, the decision would be easier to make with a higher success rate. If the decision has been made as buying from the outsource suppliers, then the search for finding the right supplier according to company needs will be the focus. And there are different types of contracts such as fixed-price contracts, cost-plus contracts, and time and materials contracts should be considered after finding the most appropriate supplier. Lastly, the right contracts should be chosen according to risks and uncertainties that company can have face in the future.

Annotated bibliography

Bajec, M., Jakomin, I. (2008). A make-or-buy decision process for outsourcing: "The article provides a make-or-buy decision process methodology that any manager can implement – whatever the size or industrial type of the organization". It has clear explanation regards to steps that should be taken into consideration by giving a make or buy decision.

Serrano, R., Ramirez, M., Gasco, J. (2018). Should we make or buy? An update and review: The article provide a new perspective to the make or buy decision by developing a theoretical framework to help managers. The results suggest that "practitioners should combine the resource-based view, strategic management and transaction cost economics theories in order to assess manufacturing location decisions".