Make Versus Buy Case

ABC Ltd. is a manufacturing company engaged in the manufacturing of valves. They have been in the business for last 3 years and have been manufacturing only one type of valves. They started their business initially with sales of 10,000 valves per month and now they have grown the volume to about 50,000 valves per month. They have been buying all the raw material for the valve and were doing all the manufacturing in house. Now they have established themselves in the market and are planning to expand and produce different varieties of valves. They have their plant in the main city and the total area of the plant is 50,000 sq. ft. Now if ABC expands its operations and continues with its manufacturing activities in-house, it would need another 50,000 sq. ft. of land area to do so. In the recent times however land prices in the area have more than doubled. Land is still available but with great difficulty.

Mr. Mohan, the production head of ABC Ltd., has been successful with the production of valves and has seen the production levels continuously increasing. He has however been facing the problem of quality complaints which have gone up from an average of 0.2 % in the previous 2 years to 0.5 % this year. Also, he is finding that there is a high level of dissatisfaction among the workers regarding their workload as well as their salary levels. The workers are regularly complaining about the over work. Mr. Mohan has also found that the workers have been spending lot of time on tea breaks, lunch breaks and even in between the production cycles when they spend a lot of time talking to each other. Due to insufficient workers and staff, he is unable to take strict action and the workers are taking advantage of this situation. For completing the work and delivering the products on a timely basis, he has to employ workers on overtime and his overtime cost has also increased 3 times. Mr. Mohan is concerned about the new expansion plan of the management and is worried about where the new workers would come from as he is already finding a shortage of workers for the existing job. He has requested that management not expand immediately but rather improve and consolidate the existing set up. He has sent his request to Mr. S. Kumar, Director - Operations. Mr. Kumar has gone through the request of Mr. Mohan and called a meeting of all the department heads and explained the situation to all concerned. Mr. Johnson, the Marketing Manager, has expressed very bullish prospects about the company's growth and said that the company should take advantage of growing economy and ABC's established brand image and definitely go for the expansion. Mr. Olek, the Finance Manager, has also expressed support for Mr. Johnson's position and indicates that expansion will result in economy of scale for the products and will further increase the profitability of the company. Mr. Mohan again highlighted his problems regarding the availability of manpower as well as production controls and the effects on quality and productivity. Mr. Johnson then asked Mr. Mohan if outsourcing the production of the new valves will be the better option. Mr. Mohan is very skeptical about the outsourcing option as he feels that outside agencies always charge more thereby cutting into his own profitability.

He also worries about the possible problems with deliveries. Mr. Kumar asked the Mr. Chen who is the Purchase Manager about his views. Mr. Chen indicated that since suppliers are also interested in doing business it was not very likely that delays would be a great source of concern as this would mean that they too would incur losses. Mr. Olek, the Finance Manager, said that he would look at cost comparison for buying versus in-house manufacturing. After listening to all the views, Mr. Kumar told Mr. Mohan to work out the cost of production for future sales as per the forecast given by the Marketing department.

He also told Mr. Chen, the Purchasing Manager, to collect the details of the future requirements to get the purchase cost details for a few components of the valves. Mr. Mohan and Mr. Chen have collected their data and they have presented the data in the meeting called by Mr. Kumar to review the plan. First the marketing head Mr. Smith presented his market forecast and then Mr. Mohan presented his report and explained the details as follows.

One supervisor with monthly salary of $5,000 with expected increase of 10 % per year.

Direct wages of worker as $4 per unit. With 10 % reduction in second year, no change in 3rd year and increase of 10 % every subsequent year.

Material cost of $14 per unit with an increase of 10 % every year.

Power and fuel cost of $2 per unit with increase of 10 % every year.

Indirect labor as 50 % of direct labor.

They will have to buy a new machine with a cost of $500,000. With usable life of 5 years Mr. Chen explained his details as follows:

Component price from supplier at $20 for the first 2 years with an increase of 10 % every subsequent year.

Transportation cost of $2 per unit for the first year with increase of $0.20 every subsequent year.

Inventory cost (storage cost) as 5 % per year of the basic material cost. Mr. Smith then gave the sales forecast for next 5 years as follows:

Year 1 2 3 4 5 Sales quantity 300,000 500,000 700,000 900,000 1,000,000

Questions 1. Give 5 reasons why management should outsource its manufacturing (buy). (5 marks)

2. Give 5 reasons why management should continue in-house manufacturing (make). (5 marks)

3. Taking all the information given above develop two tables that can be used to compare the cost of manufacturing in-house versus the cost of procurement. (30 marks)

4. Is it economical for ABC Ltd. to buy the product from the market or to manufacturing in-house? Why?(5 marks)

5. Are there any other factors for considerations? What? (5 marks)