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 they want to expand and continue doing all the activities of
manufacturing of all the varieties in house, they would need another 50,000 sq.ft. of the area. In the
recent times, the land prices in the area have more than doubled in the last 3 years and still land is
available with great difficulty. Mr. Mohan is the production head of ABC Ltd. and has been successful
with the production and the level is continuously increasing. But in recent times, he is facing the problem
of quality complaints which have gone up from average 0.2 % in previous 2 years to 0.5 % this year. Also,

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he is finding that there is a high level of dissatisfaction among the workers regarding workload as well as
salary levels. The workers are regularly complaining about the over work.

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Although, Mr. Mohan has found that the workers have been spending lot of time on tea breaks, lunch
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breaks and even in between the production spending lot of time talking to each other. But, 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 timely, he has to employ workers on
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overtime and his overtime cost has also increased 3 times. Mr. Mohan is worried about the new
expansion plan of the management and is worried where the new workers would come from as he is
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already finding shortage of workers for the existing job. He has requested the management not to go for
expansion immediately and look at improving and consolidating the existing set up. He has sent his
request to Mr. S. Kumar Director – Operations.
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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. The marketing manager has expressed very bullish prospect
about the company’s growth and said that the company should take advantage of growing economy and
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established brand image of the company and definitely go for expansion. The finance manger also
expressed that this will result in economy of scale for the products and will further increase the
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profitability of the products. Mr. Mohan again expressed his problems regarding availability of
manpower as well as production control and effect on quality and productivity. The Marketing manager
asked the Production manager about the option of outsourcing. Mr.
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Mohan is skeptical about the outsourcing option as he felt that the outside agency will always charge
more as he will try to make his profit as well and also is worried about the possible problems of
deliveries. Mr. Kumar asked the Mr. Naresh who is the Purchase manager about his views. He said that
since the suppliers would also be interested in doing the business, they would not like to delay as with

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 delay they also incur loss. The Finance manager said that we can look at cost comparison for buying
against 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. Naresh to collect the
details of the future requirements to get the purchase cost details for few components of the valve.

Mr. Mohan and Mr. Naresh 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. Suresh presented his market
forecast and then Mr. Mohan presented his report and explained the details as follows.

One supervisor with monthly salary of Rs. 5000 with expected increase of 10 % per year. Direct wages of

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worker as Rs. 4 per unit. With 10 % reduction in second year, no change in 3rd year and increase of 10 %

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every subsequent year. Material cost of Rs. 14 per unit with an increase of 10 % every year. Power and

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fuel cost of Rs. 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 Rs. 50 lac. With usable life of 5 years

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Mr. Naresh explained his details as follows:
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Component price from supplier at Rs. 20 for the first 2 years with an increase of 10 % every subsequent
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year. Transportation cost of Rs. 2 per unit for the first year with increase of Rs. 0.20 every subsequent
year. Inventory cost ( storage cost ) as 5 % per year of the basic material cost.

The Marketing manager has given the sales forecast for next 5 years as follows:
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Year 1 2 3 4 5 Sales quantity 300000 500000 700000 900000 1000000

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Questions
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1. Based on this data, is it economical for ABC Ltd.to go for buying the product from market or
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manufacturing in house.

Manufacturing cost case:

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 When the company goes for adopting the plan of in-house production or manufacturing of
Valves.
The Manufacturing cost can be calculated below:

Year 1 2 3 4 5 Total

Sales 3,00,000 5,00,000 7,00,000 9,00,000 10,00,000 34,00,000

Per unit
Cost:
Direct
Material 14.00 15.40 16.94 18.634 20.4974
Direct
Labour 4.00 3.60 3.60 3.96 4.356

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Power &
Fuel 2.00 2.20 2.42 2.662 2.9282

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Indirect
Labour

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(50% of
direct
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Labour) 2.00 1.80 1.80 1.98 2.178

Total
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Variable
Cost P.U 22.00 23.00 24.76 27.24 29.96
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Variable
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Cost Per
Year 66,00,000 115,00,000 173,32,000 245,12,400 299,59,600 899,04,000
Supervisor
salary 60,000 66,000 72,600 79,860 87,846 3,66,306
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Machinery
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P.Y Cost 10,00,000 10,00,000 10,00,000 10,00,000 10,00,000 50,00,000

Total Cost
P.Y 76,60,000 125,66,000 184,04,600 255,92,260 310,47,446 952,70,306
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Procurement cost case:

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 When ABC Ltd. goes for outsourcing the project the procurement cost can be calculated
below:

Year 1 2 3 4 5 Total

Sales 3,00,000 5,00,000 7,00,000 9,00,000 10,00,000 34,00,000

Per Unit
Cost:
Material
Cost 20 20 22 24.2 26.62
Transport
Cost 2 2.2 2.4 2.6 2.8

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Inventory

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Cost (5%

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of Basic

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mat. Cost
P.Y) 1 1 1.1 1.21 1.331

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Total
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Cost 23 23.2 25.5 28.01 30.751
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Total 69,00,00 116,00,00 178,50,00 252,09,00 307,51,00

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Cost P.Y 0 0 0 0 0 923,10,000

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Total Cost:
Manufacturing case - 952,70,306
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Procurement case - 923,10,000

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After evaluating both the given options it is clearly visible that the case II suggested by
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Mr Naresh yields more economic benefit for the company as compared to the plan of
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home production suggested by Mr. Mohan.

2. What other factors should ABC Ltd. look at for making this decision?
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According to the given case the economic factor between the two options clearly influences the
decision, but even if the two costs would have been equal or the cost of
procurement/outsourcing would have been slightly higher than the cost of home production, the
preferred option should still be outsourcing ,as outsourcing increases the flexibility and
management capability of the organisation along with the risk bearing capacity of the entity.

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 Besides the economic factors there are many other factors which are necessary to be
considered before making a 'make or buy decision'. Some of these factors are listed below:
 Volume of Production: The quantity or volume of production affects the make or buy
decision to the greater extent. If the volume of production is high, it favours the make
decision and low volume favours buy decisions.
 Cost Analysis: The cost to buy an item should include-purchase price of the item or
component, transportation cost, sales tax and octopi, procurement cost, carrying cost,
receiving and incoming inspection costs. The analysis of these two costs helps take decision
whether to make or buy.
 Utilization of Production Capacity: The organization, which has created large production
capacity, favours the decision to make
 Integration of Production System: The vertical integration favours the make decision
whereas horizontal integration favours buy decision.
 Availability of Manpower: Availability of skilled and competent manpower favours makes
decision where as scarce manpower prefers buy decision.
 Secrecy or Protection of Patent Right: This condition favours the make decision.
Fixed Cost: A lower fixed cost favours the decision to make and higher fixed cost the make

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decision.
Availability of competent suppliers or vendors

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 Quality and reliability of vendors
 Contractor’s capacity to perform

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 Affects of uncertainty and risks
 Return on investment
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In the given case also as the case study itself says that for expanding the business the
company is already facing problems related to quality complaints by customers and labour
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problems due to several reasons among the employees the company. The major problem is
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also of the requirement of increased labour for increased production the company needs to
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consider these factors very well before making the 'Make or buy decision' besides the
economic factor.
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