Make/Buy Decisions

Make or Buy Decisions (Insourcing versus Outsourcing)

 

  • ·         Almost any business function can be outsourced including production activities or support functions such as payroll, information technology, distribution, and technical support.  The key question is whether the organization wants to perform the activities with its own resources and employees, or hire a third party to perform the activities.

 

To analyze a make/buy or insource/outsource decision, managers should compare the relevant costs of performing the activities internally to the cost of buying from an external supplier.  In other words, managers should include only those costs that would change depending on whether the company outsources or not.  As with any decision, managers must also consider whether there are opportunity costs or benefits lost by performing an activity internally rather than buying it externally.

 

  • ·        Incremental Analysis – Suppose a company wants to outsource its packaging operation.  After several discussions, the prospective supplier agrees to a price of $3 per unit for all packaging-related activities.  The agreement includes a three-year contract for a minimum of 200,000 units per year.  Should the company continue its packaging operation internally or should it outsource?  First, the company should first consider whether all costs associated with the packaging activities are relevant.  Another way to think about it is to consider which costs are avoidable, or can be eliminated by outsourcing.  All variable costs are relevant, or avoidable by outsourcing.  But what about fixed costs?  One would have to look at fixed costs line item by line item.  Fixed supervisory costs are avoidable and would be considered in the analysis.  Other fixed overhead costs such as depreciation on machines and the packaging department’s common facility costs such as rent, utilities, and insurance are probably not avoidable since they would be incurred despite the outsourcing decision.  In addition depreciation is a sunk cost that results from a prior decision to purchase capital equipment.  The next question management must consider is whether keeping the packaging in-house has any opportunity costs, e.g. are there better uses for the resources devoted to packaging.  If there are better uses, then these potential benefits (opportunity costs) must be in the incremental analysis.

 

  • ·        Qualitative Analysis – Before making a final decision on outsourcing, a firm may want to consider other quantitative factors, such as:

 

  • o       Will the quality of the packaging be as good or even better, the company can provide internally?
  • o       Will the supplier be reliable in delivering the packaging?
  • o       What will happen if demand for the product rises above 200,000 units?  Does the supplier have the capacity to meet the increased demand?  Will the supplier charge a higher or lower price for the additional units?
  • o       What will happen in three years? Will the supplier increase the price significantly?  Going back to internal packaging would be difficult after the space has been converted for another purpose.
  • o       What if the expected profit from expanding the other product line has been substantially over-or underestimated?
  • o       Does outsourcing the packaging create any additional risks?