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COST ANALYSIS FOR 'MAKE-OR-BUY' DECISIONS FOR MANUFACTURING INDUSTRIES Research · January 2013 DOI: 10.13140/RG.2.2.22855.70566

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International Research journal of commerce, Business and Social science(IRJCBSS) VOL.1.No.9,pp.151-156 (ISSN 2277-9310) Dec 2012 COST ANALYSIS FOR 'MAKE-OR-BUY' DECISIONS FOR MANUFACTURING INDUSTRIES Katikar R S1 Asst. Professor ,Sinhgad College of Engg, Pune -411041 Maharashtra India 1 [email protected] Dr Pawar M S2,Professor & Principal,B .Mane Institute of Technology,Solapur-413002Maharashtra India,[email protected]

Abstract The make-or-buy question has always been a concern of complex nature which represents a fundamental dilemma faced by many companies. The cut-throat competition compels all the manufacturing and services companies to re-evaluate their existing processes, technologies, products and services in order to find an opportunity to positively impact the bottom line by making strategically-drawn out make-or-buy decisions. 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 vendor). Outsourcing decisions are based on the difference in the cost of purchasing or buying a product or service from an external supplier compared to the cost of producing the item or providing the service in house. One important aspect of cost management is determining whether to make or buy components in a product. A complete and correct assessment of the various elements of the cost is essential to make sound economic decisions. In this paper an attempt is made to the determination of cost to make the item and cost to buy it with a case study. In this paper a total cost approach method is used for finding the cost of one part in a valve product for taking the decision about a part either to make or buy .This method helps the manager for taking the decision about a part in a product to make in house or outsource before going to manufacturing. Keywords: Make or buy, outsourcing, procurement, cost analysis.

1. Introduction No firm can manufacture each-and every item of its product. It is neither possible nor desirable. Items which do not form the company's product line are always purchased from outside. There are different materials used for manufacturing of items in a product which requires a different manufacturing process. A daily question faced by managers is whether the right components and services will be available at the right time to ensure that production can occur. Additionally, the inputs must be of the appropriate quality and obtainable at a reasonable price. Traditionally, the make option tended to be favored by many large firms, resulting in backward integration and ownership of a large range of manufacturing and assembly facilities. Major purchases were mainly confined to raw materials and components which were than processed in house. But the increased global competition in recent years created pressures to reduce costs, downsizing the workforce and focusing on the form’s core competencies. Hence the trend is now toward outsourcing for goods or services that had been previously provided in house .This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal production and opportunity costs with purchase cost and assesses the best uses of available facilities. Consideration of an in-source (make) option implies that the industry has available capacity for that purpose or has considered the cost of obtaining the necessary capacity. Relevant information for this type of decision includes both quantitative and qualitative factors. Usually, organizations compare the standard cost as determined by cost accounting with the price a supplier is quoting in making a make/buy decision. This is almost always fallacious. The standard cost includes fixed costs that will continue to be part of operations whether the product is manufactured inhouse or not. In many cases, the supplier’s cost will be lower than the in-house standard cost; however, the reality is that overall industry costs and the costs of other products will increase if this part is outsourced; this is because fixed costs will be spread over a smaller number of units after a part is outsourced. The exception to this would be if a company shut down a portion of its operations (reduced fixed costs) and considered outsourcing an entire manufacturing operation; in this case, it could eliminate a portion of its fixed cost and possibly have a lower product cost. Detailed cost analysis would need to be performed to determine whether a part is to be make in-house or buy form outside. The remainder of the paper is organized as follows. A review on make or buy decision, as it relates to cost and outsourcing will be given in the section 2. Followed by Factor Influencing Make-or-buy decisions will be given in section 3. Cost analysis and economic model for make-or-buy decisions is

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explained in Section 4, In Section 5 case study will be illustrated. Finally, concluding remarks will be given in Section 6 2. Literature review We reviewed the pertinent studies that discussed on the make or buy decision, as it relate to production cost and outsourcing. Henrik Brandes et al. (1997) argued that three kinds of reasons for decision considering outsourcing, cost efficiency, financial problem and core competence. They indicated, especially, a combination of focus on cost efficiency reasons and core competences tends to lead a greatest probability of success. In cost perspective, Mabin and Balderstone (2000) introduced the CPCM (Contribution per Constraint Minute) method of make or buy analysis, which makes the decision using the traditional costing method to decide whether to make or buy. They showed that the standard cost method for making the outsourcing decision was inferior to the CPCM approach, which follows the TOC (Theory of Constraints) principle (Jaydeep Balakrishnan and Chun Hung Cheng, 2005). Edward and Geoffrey (2002) developed an engineering-based model of outsourcing, and showed relations between optimal outsourcing fraction and cost structures, as well as technological change. In addition, there were lots of researches for option of outsourcing it had been approached from the cost viewpoint. Balakrishnan(1994)\cite{balakrishnan} investigated make or buy decision that compared the cost of administering transactions inside a firm and across markets. To decide make or buy, Lynn and James (2002) studied from cost system approach. They analyzed cost accounting systems, such as ABC (Activity-based costing), DC (Direct costing), TCA (Traditional cost accounting) and TOC (Theory of constraints), and showed significant differences between the solutions obtained using the TOC/LP and other three accounting system. The cost of every minute worked at any resource (minute rate) and the subsequent outsourced quantity and net profit can be computed using the computational procedure suggested by Mishra et al (2007). Souren et al(2005) assessed the quality of the TOC based approach to generate good or even optimal solutions. Varying results were obtained when compared with other product-mix decision tools considering various product-mix situations such as type and number of constraints, requirement of integer or non-integer solution, costs involved and nature of objective function. Coman A.and Ronen B (2000), Chakrabarty ea tl(2006), Ray A ea tl(2007)studied the performance measurement aspect of TOC with standard cost accounting . In this paper we formulate an economical make or buy decision model which will help for taking the decision about a part to be make or buy outside on based on detail cost analysis of a parting a product. 3. Factor Influencing Make-or-buy decisions The following factors generally influence make-or-buy decisions: (a) Cost analysis: Cost analysis refers to the determination of cost to make an item as well as cost to buy it. The cost to make an item should include the estimated cost of raw materials, direct labour, depreciation, interest on investment; insurance and property taxes, incremental administrative overheads; Incremental fixed cost (procurement or setup cost) and carrying cost of raw materials and work-in-progress. The cost to buy an item should include purchase- price of part, transportation cost, octroi and sales tax, incremental procurement cost and carrying cost etc. (b) Capacity Available:- If firm has available capacity in equipments, necessary skills and time it makes sense to produce items in-house otherwise go for outsource. (c)Expertise/Skill: - If the need experience is lacking in the firm, buying might be better alternative. (d)Quality consideration: - Outside suppliers who specialize can usually offer higher quality products than what the firm can produce. But unique quality requirement or the desire to closely monitor the quality may cause a firm to decide to make. (e)The nature of Demands: - When the demand for a product is high and stable. It is better for the firm to produce the item rather than buy. Alternatively, when fluctuation in demand or small orders have to be handled, it is better to buy the item from multiple sources who are specialists. (f) Utilizations of External capabilities: Exploit external sources, learn from outsiders and increase product diversity etc .Access outside sources’ competence or technology advantages difficult or costly to attain in-house 4. Cost analysis and Economical model for make-or-buy decision. Cost analysis refers to the determination of cost to make the item and cost to buy it. A complete and correct assessment of the various elements of the cost is essential to make sound economic decisions. The analysis is based on annual requirements of components against the following elements; a) Raw material: The raw material cost consists of cost raw materials less value recovered due to the sale

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of scrap . The raw material cost is considered towards the cost to make. However, if the raw material is supplied to the vendor free of cost, the cost of such materials also requires to be added to the cost to purchase. b)Labour cost: Labour cost implies the wages and costs of other benefits payable to the workmen engaged on the job. c) Tooling cost: Jigs and fixtures generally require to be made if the item is to be machined in-house. The Jigs and fixtures once made maintain their accuracy only for certain quantity, say "n" pieces, after which again a new set of jigs and fixtures require to be made. The cost of tooling thus requires to be amortized over “n" pieces and the annual cost of such tooling require adding to the "cost to make". At times, when an item is purchased from outside vendors, certain special cutting tools and jigs and fixtures require to be supplied to the vendor free of cost. The cost of such tooling therefore requires to be considered separately as tooling cost towards "cost-to-buy". d) Overhead cost: Overhead cost includes indirect material cost, indirect labour cost, indirect expenses .In a manufacturing industries over head cost can broadly be divided into three category: (i) factory or works where production is done,(ii)office and administration ,where routine as well as policy matters are decided: and (iii) selling and distribution where products are sold and finally to the customer. e) Set -up Cost: Set-up cost is the "preparation cost" of the machines and it varies depending upon the number of production runs in a year . f) Procurement cost: The procurement cost is the cost of raising a purchase order and processing the deliveries from the vendor(s) and it varies depending upon the frequency of receipts of the item from' the vendors(s). g) Purchase cost: Purchase cost includes the price given to the vendor, packing and forwarding; excise, sales tax, transport cost, octroi, etc. h) Capacity cost: Capacity cost implies the cost of capacity rendered idle if the number of items currently being manufactured are purchased; Such a cost requires to be 'added to the "cost to buy" for making a comparison of make or buy decision.. Following figure No.1 shows the economic model for taking the decision about a part to make inhouse or buy outside on the basis of total cost approach.

Fig.no1.Economic model for make or buy decision 5. Case study on make-or-buy decisions This case study is based on a detailed study conducted at a medium size valve manufacturing company , located at Chakan in Pune district (Maharashtra)in -the area of make-or-buy decisions. The study was conducted, with an object to evaluate and justify whether a adaptor part of a 6”#150 tunion plate valve actuator is to be make or outsource based on total cost approach .Following table no.1 shows the operation performed ,machine used, cycle time, setup time, batch quantity, total time for machining a adaptor part. In company there are total nine different machines to machine the different parts of valve .the machine are

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used for a machining adaptor and other details are given in table no.2 for cost analysis. Operators rate monthly [(Rs.9000/26(days)/7(hrs))= Rs.49/hr]. Table No.1.Data for operation and time for a part Part Name Adapter

Operation Turning Drilling Milling Boring

Machine CNC Turning DX 200 VMC1000 HMC500 HBM-China VMC1000 HMC500

Machine basic Cost Area required Sq.ft Interest rate in % Depreciation rate in % Machine life Rent in Rs. per Sq. Foot Tooling Cost(Avg) Consumable(Avg) Rent/ hr Energy Charges/hr Depreciation/hr Interest/hr Maintenance/hr Total Overhead Contribution of M/c cost to total cost of all M/c Over heads In Rs/hr Overhead structure Position Manager Shop In-charge Supervisor Helper

3000000 400 16 10.3 10 years 16 12 4 13 40 48 80 10 207 6% 11

cycle time 33.5 40 44 20

Setup time 60 80 40 120

Batch Qty 100 100 100 100

Total Time 34.1 40.8 44.4 21.2

CNC Turning DX 200 HBM-China

5700000 500 16 10.3 10 years 16 60 4 16 25 91 152 10 358 12% 22

1552200 150 16 10.3 10 years 16 18 4 5 25 25 41 10 129

9000000 700 16 10.3 10 years 16 60 4 22 100 112 240 10 549

3% 6

19% 34

For in house manufacturing No. of position salary monthly(Rs) Total salary(Rs) 1 40000 40000 1 22000 22000 2 17000 34000 3 6000 18000 Total 96000

A similar cost analysis calculation has been done for collecting a data from vendor as given table no.2 . Table no.2 for cost comparison between inhouse manufacturing and form outside. Cost element Make in-house Raw material cost 1242.00 Labour cost(Total time X Rs/hr/pc) 115.00 Tooling cost(on machine) 82.00 Overheads i)indirect labour(∑(time on each m/c X over head rate) 39.00 ii)Depreciation of M/c used(∑(time on each m/c X depreciation rate) 154.00 iii)interest(∑(time on each m/c X interest rate/hr) 275.00 iv)cost of space used by m/c(∑(time on each m/c X rent/hr) 43.00 Variables over heads i)Consumables 9.00 ii)Electric charges(∑(time on each m/c X Energy Charges/hr) 92.00 iii)Maintenance 23.00 Purchase cost(Admin OH+Selling OH+Profit) 2063

outsource 1242.00 89.00 92.00 23.00 170.00 294.00 50.00 6.00 118.00 26.00 217.00 2327

The part taken for case study was outsource at Rs.2327/Pc. When the detailed in-house cost analysis was carried out it can be seen From Table no.2 the cost of manufacturing in-house in less than outside hence industry should go for in-house manufacturing.

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6.Conclusion In this study a economic model has been constructed, which helps to the manager to take a decision about a part in a product, when industry introduces new products, experiences increase in demand of existing products, adjudges performance of its existing vendors unsatisfactory or finds the cost of present practice of buying / manufacturing apparently high .A total cost methodology has been used for calculating cost of a part in a product and described at a length. The proposed methodology is validated by taking an example of valve manufacturing company. References 1.Balakrishnan, S., 1994.,” The dynamics of make-or-buy decisions”, European Journal of Operational Research, vol.74,pp. 552-571. 2. Chakrabarty P.S,.Majumdar G,.Sarkar B, 2006 “Constraint Resource Management and Production Related DecisionA Case study”, International Journal of Production Research, vol-86, pp-48-53 3. Coman, A. and Ronen, B., 2000,” Production outsourcing: a linear programming model for the theory of constraints”, International Journal of Production Research, vol.38, pp.1631-1639 4. Edward.G.Anderson,Jr, Geoffrey.G.Parker, 2002.” The effect of learning on the make/buy Decision”, Production and Operations Management Society, vol.11,no.3.pp.22-26 5.Henrik Brandes, Johan Lilliecreutz and Staffan Brege, 1997.” Outsourcing-success or failure?: Findings from five case studies”, European Journal of Purchasing and Supply Management, Vol.3,no.2,pp. 63-75 6.Jaydeep Balakrishnan, Chun Hung Cheng, 2005.” The Theory of Constraints and the Make-or- Buy Decision-An Update and Review”, Journal of Supply Chain Management, vol.41,pp. 40-47 7. Lynn H.Boyd, James.F.Cox, 2002.,” Optimal decision making using cost accounting Information”, International Journal of Production Research, vol.40, no.8, pp.1879-1898 8.Mabin, V.J, and Balderstone, S.J., 2000,”A Review of Goldratt’s Theory of Constraints (TOC) – lessons from the international literature 9.Mishra, D., Biswal, B.B. and Mohanty, R.P. 2007,” A comparative study of production outsourcing models with emphasis on theory of constraints based approach”, Vilakshan-XIMB Journal of Management,vol. 4,no.1, pp31-60. 10 Ray A , Sarkar B, Sanyal S,2007,” An Integrated Theory-Of-Constraints”, Proceedings of the IEEE IEEM,pp-2529 11. Souren, R., Ahn, H. and Schmitz, C., 2005, “Optimal product mix decisions based on the theory of constraints? Exposing rarely emphasized premises of throughput accounting” ,International Journal of Production Research, vol.43, pp.361-374

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