Unit II Make or buy decision

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 supplier). The buy side of the decision also is referred to as outsourcing. Make-or-buy decisions usually arise when a firm that has developed a product or partor significantly modified a product or partis having trouble with current suppliers, or has diminishing capacity or changing demand. Make-or-buy analysis is conducted at the strategic and operational level. Obviously, the strategic level is the more long-range of the two. Variables considered at the strategic level include analysis of the future, as well as the current environment. Issues like government regulation, competing firms, and market trends all have a strategic impact on the make-or-buy decision. Of course, firms should make items that reinforce or are in-line with their core competencies. These are areas in which the firm is strongest and which give the firm a competitive advantage. The increased existence of firms that utilize the concept of lean manufacturing has prompted an increase in outsourcing. Manufacturers are tending to purchase subassemblies rather than piece parts, and are outsourcing activities ranging from logistics to administrative services. In their 2003 book World Class Supply Management, David Burt, Donald Dobler, and Stephen Starling present a rule of thumb for out-sourcing. It prescribes that a firm outsource all items that do not fit one of the following three categories: (1) the item is critical to the success of the product, including customer perception of important product attributes; (2) the item requires specialized design and manufacturing skills or equipment, and the number of capable and reliable suppliers is extremely limited; and (3) the item fits well within the firm's core competencies, or within those the firm must develop to fulfill future plans. Items that fit under one of these three categories are considered strategic in nature and should be produced internally if at all possible. Make-or-buy decisions also occur at the operational level. Analysis in separate texts by Burt, Dobler, and Starling, as well as Joel Wisner, G. Keong Leong, and Keah-Choon Tan, suggest these considerations that favor making a part in-house: Cost considerations (less expensive to make the part) Desire to integrate plant operations Productive use of excess plant capacity to help absorb fixed overhead (using existing idle capacity) Need to exert direct control over production and/or quality Better quality control
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Design secrecy is required to protect proprietary technology Unreliable suppliers No competent suppliers Desire to maintain a stable workforce (in periods of declining sales) Quantity too small to interest a supplier Control of lead time, transportation, and warehousing costs Greater assurance of continual supply Provision of a second source Political, social or environmental reasons (union pressure) Emotion (e.g., pride)

Factors that may influence firms to buy a part externally include: Lack of expertise Suppliers' research and specialized know-how exceeds that of the buyer cost considerations (less expensive to buy the item) Small-volume requirements Limited production facilities or insufficient capacity Desire to maintain a multiple-source policy Indirect managerial control considerations Procurement and inventory considerations Brand preference Item not essential to the firm's strategy

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The two most important factors to consider in a make-or-buy decision are cost and the availability of production capacity. Burt, Dobler, and Starling warn that "no other factor is subject to more varied interpretation and to greater misunderstanding" Cost considerations should include all relevant costs and be long-term in nature. Obviously, the buying firm will compare production and purchase costs. Burt, Dobler, and Starling provide the major elements included in this comparison. Elements of the "make" analysis include: Incremental inventory-carrying costs Direct labor costs Incremental factory overhead costs Delivered purchased material costs Incremental managerial costs Any follow-on costs stemming from quality and related problems Incremental purchasing costs Incremental capital costs

Cost considerations for the "buy" analysis include: Purchase price of the part Transportation costs Receiving and inspection costs Incremental purchasing costs Any follow-on costs related to quality or service

One will note that six of the costs to consider are incremental. By definition, incremental costs would not be incurred if the part were purchased from an outside source. If a firm does not currently have the capacity to make the part, incremental costs will include variable costs plus the full portion of fixed overhead allocable to the part's manufacture. If the firm has excess capacity that can be used to produce the part in question, only the variable overhead caused by production of the parts are considered incremental. That is, 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.
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While cost is seldom the only criterion used in a make-or-buy decision, simple break-even analysis can be an effective way to quickly surmise the cost implications within a decision. Suppose that a firm can purchase equipment for in-house use for $250,000 and produce the needed parts for $10 each. Alternatively, a supplier could produce and ship the part for $15 each. Ignoring the cost of negotiating a contract with the supplier, the simple break-even point could easily be computed: $250,000 + $10Q = $15Q $250,000 = $15Q $10Q $250,000 = $5Q 50,000 = Q Therefore, it would be more cost effective for a firm to buy the part if demand is less than 50,000 units, and make the part if demand exceeds 50,000 units. However, if the firm had enough idle capacity to produce the parts, the fixed cost of $250,000 would not be incurred (meaning it is not an incremental cost), making the prospect of making the part too cost efficient to ignore. Stanley Gardiner and John Blackstone's 1991 paper in the International Journal of Purchasing and Materials Management presented the contribution-per-constraint-minute (CPCM) method of make-or-buy analysis, which makes the decision based on the theory of constraints. They also used this approach to determine the maximum permissible component price (MPCP) that a buyer should pay when outsourcing. In 2005 Jaydeep Balakrishnan and Chun Hung Cheng noted that Gardiner and Blackstone's method did not guarantee a best solution for a complicated makeor-buy problem. Therefore, they offer an updated, enhanced approach using spreadsheets with built-in liner programming (LP) capability to provide "what if" analyses to encourage efforts toward finding an optimal solution. Firms have started to realize the importance of the make-or-buy decision to overall manufacturing strategy and the implication it can have for employment levels, asset levels, and core competencies. In response to this, some firms have adopted total cost of ownership (TCO) procedures for incorporating non-price considerations into the make-or-buy decision.

VALUE ENGINEERING
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Origins of Value Engineering

Value engineering began at General Electric Co. during World War II. Because of the war, there were shortages of skilled labour, raw materials, and component parts. Lawrence Miles, Jerry Leftow, and Harry Erlicher at G.E. looked for acceptable substitutes. They noticed that these substitutions often reduced costs, improved the product, or both. What started out as an accident of necessity was turned into a systematic process. They called their technique value analysis. Meaning

Value Engineering is a fuction oriented, systematic team approach and study to provide value in a product, system or service. Often, this improvement is focused on cost reduction; however other important areas such as customer perceived quality and performance are also of paramount importance in the value equation. Value Engineering techniques can be applied to any product process procedure system or service in any kind of business or economic activity including health care, governance, construction, industry and in the service sector. Value Engineering focuses on those value characteristics which are deemed most important from the customer point of view. Value Engineering is a powerful methodolgy for solving problems and/or reducing costs while maintaining or improving performance and quality requirements. Value Engineering can achieve impressive savings, much greater than what is possible through conventional cost reduction exercise even when cost reduction is the objective of the task. The Job Plan Value engineering is often done by systematically following a multi-stage job plan. Larry Miles' original system was a six-step procedure which he called the "value analysis job plan." Others have varied the job plan to fit their constraints. Depending on the application, there may be four, five, six, or more stages. One modern version has the following eight steps: 1. 2. 3. 4. 5. 6. 7. 8. Preparation Information Analysis Creation Evaluation Development Presentation Follow-up

Four basic steps in the job plan are:

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Information gathering - This asks what the requirements are for the object. Function analysis, an important technique in value engineering, is usually done in this initial stage. It tries to determine what functions or performance characteristics are important. It asks questions like; What does the object do? What must it do? What should it do? What could it do? What must it not do? Alternative generation (creation) - In this stage value engineers ask; What are the various alternative ways of meeting requirements? What else will perform the desired function? Evaluation - In this stage all the alternatives are assessed by evaluating how well they meet the required functions and how great will the cost savings be. Presentation - In the final stage, the best alternative will be chosen and presented to the client for final decision.

Procedure VE
VE follows a structured thought process to evaluate options as follows. Gather information 1.What is being done now? Who is doing it? What could it do? What must it not do? Measure 2.How will the alternatives be measured? What are the alternate ways of meeting requirements? What else can perform the desired function? Analyze 3.What must be done? What does it cost? Generate 4.What else will do the job? Evaluate 5.Which Ideas are the best? 6. Develop and expand ideas
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What are the impacts? What is the cost? What is the performance? 7.Present ideas Sell alternatives Benefits of Value Engineering

Lowering O & M costs Improving quality management Improving resource efficiecy Simplifying procedures Minimizing paperwork Lowering staff costs Increasing procedural efficiency Optimizing construction expenditures Developing value attitudes in staff Competing more sucessfully in marketplace

How is Value Engineering Applied ? The technique of Value Engineering is governed by a structured decision making process to assess the value of procedures or services. Whenever unsatisfactory value is found, a Value Management Job plan can be followed. This procedure involves the following 8 phases : 1. Orientation Recommendation 2. Information 3. Function 8. Audit 4. Creativity 5. Evaluation 6.

7. Implementation

TIME VALUE OF MONEY The time-value of money is the relationship between interest and time. i.e.

Figure 2 : Time-Value of Money

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Money has time-value because the purchasing power of a dollar changes with time. INTEREST FORMULAE (Discrete Compounding and Discrete Payments) Notations:
i = The annual interest rate n = The number of annual interest periods P = A present principal sum A = A single payment, in a series of n equal payments, made at the end of each annual interest period F = A future sum, n annual interest periods hence

1. Single-Payment Compound-Amount Factor

F = P.[1 + i]^n

Example 1 : Let the principal P = $1000, the interest rate i = 12%, and the number of periods n = 4 years. The future sum is:
F = $1000 [1 + 0.12] ^ 4 = $1,573.5

Figure 4 : Cash Flow for Single Payment Compound Amount Figure 4 shows the cash flow for the single present amount (i.e. P = 1000) and the single future amount (i.e. F = $1,573.5). 2. Single-Payment Present-Worth Factor
F P = ========= [1 + i]^n

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The factor 1.0/[ 1 + i ]^n is known as the single-payment present-worth factor, and may be used to find the present worth P of a future amount F. Example 1 : Let the future sum F = $1000, interest rate i = 12%, and number of periods n = 4 years. The single payment present-worth factor is:
F $1000.00 P = ========= = ============== = $635.50. [1 + i]^n [ 1 + 0.12 ]^4

The present worth P = $635.50. Example 2 : Let the future sum F = $1,573.5, the interest rate i = 12%, and the number of periods n = 4 years. The single payment present-worth factor is:
F $1573.50 P = ========= = ============== = $1000.00. [1 + i]^n [ 1 + 0.12 ]^4

The present worth P = $1000.00. 3. Equal-Payment Series Sinking-Fund Factor Given a future amount F, the equal payments compound-amount relationship is:
i A = F * --------------[ 1 + i ]^n - 1

A = required end-of-year payments to accumulate a future amount F. Example 1: Let F = 1000, i = 12%, and n = 4 years.
0.12 A = 1000 * ------------------ = 209.2 [ 1 + 0.12 ]^4 - 1

4. Equal-Payment-Series Capital-Recovery Factor A deposit of amount P is made now at an interest rate i. The depositor wishes to withdraw the principal plus earned interest in a series of year-end equal payments over N years, such that when the last withdrawl is made there should be no funds left in the account.
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Figure 6 : Schematic of Equal-Payment-Series Capital Recovery Figure 6 summarizes the flow of disbursements and receipts (from the depositors point of view) for this scenario. Equating the principle $P (plus accumulated interest) with the accumulation of equal payments $A (plus appropriate interest) gives:
[ [ 1 + i ]^n - 1 ] P [ 1 + i ]^n = A ------------------i

which can be rearranging to give:

i * [ 1 + i ]^n A = P * --------------[ 1 + i ]^n - 1

This is the case of loans (mortgages). Example 1: Let P = 1000, i = 12%, and n = 4 years
0.12 * [ 1 + 0.12 ]^4 A = $1000 * --------------------- = $329.2 [ 1 + 0.12 ]^4 - 1

5. Equal-Payment-Series Present-Worth Factor This can be described as

[ 1 + i ]^n - 1 P = A * ---------------

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i * [ 1 + i ]^n

Example 1: Let A = 100, i = 12%, and n = 4 years.

[ 1 + 0.12 ]^4 - 1 P = 100 * --------------------- = 303.7 0.12 * [ 1 + 0.12 ]^4

6. Uniform Gradient-Series Factor Often periodic payments do not occur in equal amounts, and may increase or decrease by constant amounts (e.g. $100, $120, $140, $160 .... $200). The gradient (G) is a value in the cash flow that starts with 0 at the end of year 1, G at the end of year 2, 2G at the end of year 3, and so on to (n-1)G at the end of year n. This can be described as
*-* | 1 n | A = G . | - - --------------- | | i [ 1 + i ]^n - 1 | *-*

Example 1 : Let G = 100, i = 12%, and n = 4 years.

*-* | 1 4 | A = $100 . | ---- - ------------------ | = $ 135.9 | 0.12 [ 1 + 0.12 ]^4 - 1 | *-*

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