How to Choose Whether to Make or Buy in Manufacturing

Manufacturers often grapple with the decision to produce a component in-house or purchase from an outside vendor. Ultimately the decision to outsource a portion of the value chain should be carefully examined and scored against both qualitative and quantitative measurements.

While vertical integration has its advantages – less dependency on suppliers, manage quality – there are some challenges such as capital investment and labor management. At times, decisions to dismantle vertical integration are made in lieu of efforts to improve an inefficient manufacturing process. Making a decision based on gut-feelings or opinions that are not supported by financial data is careless and costly.

Qualitative Factors

Prior to calculating the cost implications of outsourcing a particular item, the company should weigh the qualitative determinants in the options. In the 2003 book, World Class Supply Management, the authors suggest that items that fit under one of the following three categories are strategic in nature and should be internally produced:

  1. The item is critical to customer differentiation (e.g., “Made in America”)
  2. The item requires specialized designs and manufacturing skills, and
  3. The item fits well within the firm’s core competencies

Evaluating subassemblies against these three criteria first may condense the list of items that should be assessed for make versus buy.

Outsourcing introduces considerable supply chain risk such as potentially diminished quality and reliability of deliveries. Lead times and delivery schedules must be managed.

Additionally, suppliers may not do small production runs thereby requiring your company to maintain higher inventory levels. These risks would need to be mitigated before committing production to contractors.

Quantitative Factors

The biggest challenge to solving the quantitative equation is knowing what it costs to product the item. Using the fully loaded cost is a mistake and inflates the internal cost of production for this analysis. Only those costs that are incremental should be considered.

Incremental costs would not be incurred if the part were purchased from an outside source. Total costs minus costs that are not avoidable represent the incremental costs of producing the subassemblies. Incremental production costs would almost certainly include direct material and freight in. Direct and indirect labor, a portion of variable overhead (inventory carrying costs) and administrative expenses may be included. However it is likely that these costs would be incurred regardless. Therefore unavoidable costs should not be considered as a cost of the subassembly for a make versus buy analysis.

Additionally, fixed costs, under conditions of sufficient idle capacity, are not incremental and should not be considered as part of the cost to make the part. Similarly, the purchase price, delivery costs, and incremental indirect costs should be included as costs on the purchase side of the equation.

If the factory is operating at full capacity, a deeper analysis is required. Selecting the optimal components to manufacture will free up capacity to produce items that would be more expensive to buy on the outside. If multiple parts are being manufactured, follow this step by step analysis:

  1. Determine the capacity of the plant (in terms of labor hours and/or machine hours)
  2. Calculate the incremental cost to produce versus purchase for each item under consideration
  3. Choose to produce the items with the greatest incremental savings over purchase until plant capacity if filled, outsource the remaining. 

Develop a Decision Tree

Create a decision tree and include the following considerations:

Favor manufacturing in-house:

  • Less expensive to make the part
  • Use of excess plant capacity 
  • Control over quality
  • Control of lead time
  • Greater assurance of continual supply

Favor purchasing externally:

  • Higher quality from supplier
  • Less expensive
  • Insufficient capacity
  • Item not essential to the firm’s strategy

Conclude your decisions after multiple disciplines within the organization have contributed their insight, and only after empirical data supports the direction of outsourcing.

Joe Mocciaro, CPA, is a Partner at Bowers & Company CPAs. Reach him at 315-234-1179 or jmm@bcpllc.com.

Bowers & Company CPAs aims to offer helpful information to our clients and friends. Learn more about how we can help should your manufacturing business need accounting and financial services.

Disclaimer: To ensure compliance with requirements imposed by the Department of Treasury, we inform you any U.S. federal tax advice contained in this document or video is not intended for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

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Joe Mocciaro

Joe Mocciaro

Joe Mocciaro, CPA, CMA, is a Partner at Bowers & Company CPAs PLLC. Reach him at 315-234-1179 or JMM@bcpllc.com. Bowers & Company aims to offer helpful information to our clients and friends. Bowers & Company CPAs aims to offer helpful information to our clients and friends. Learn more about how we can help should your manufacturing business need accounting and financial services.

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