Every manufacturing company navigates make vs. buy decisions, which can be key to overall profitability and impact the strategic direction of the company. The buy side is generally fairly straightforward. Sending out a bid for quotes gives a range of cost estimates, though there can still be unknowns in quality and on-time delivery. Accurate assessments of internal costs to make a product can be much more complex, however, and have a wider impact on the overall business than anticipated. The examples in this article are written based on a machine-shop perspective, although all of them apply more broadly.
Estimating Internal Costs
It may be tempting to estimate the internal cost to run a part based solely on direct labor costs and machining cost per hour, but this often leads to a systemically high or low estimate of the make cost. Get the internal costs wrong and you might find yourself in an accounting-induced death spiral. Ultimately, these signals can force a complete exit from internal production and/or declining profits, even potential bankruptcy.
The goal of standard costing is to fully allocate costs, especially fixed costs, to products. It’s a forecast and will be incorrect to one degree or another, resulting in an accounting variance. In an effort to minimize this, annual recalculations are made and a new burden rate will govern for the following year. This is fine for accounting purposes but troublesome in a make vs. buy setting. Here’s how the accounting death spiral can play out:
Year 0 (running at or near capacity):
- $30,000,000 overhead / 250,000 hrs. produced à $120/hr. burden rate
- Make vs. buy analyses have 50/50 outcomes
Year 1 (small downturn)
- $30,000,000 overheard / 220,000 hrs. produced à $136/hr. burden rate
- Make vs. Buy starts to favor buy, leading to further volume declines as productions starts going outside
Year 2 (outsourcing underway)
- $30,000,000 overhead / 200,000 hrs. produced à $150/hr.
- Internal operations look unfavorable, all analyses result in an outsource decision
- $30,000,000 overhead / 150,000 hrs. produced à $200/hr.
- Death spiral fully underway.
There will be other effects from the shrinking volume. Undoubtedly, the company will try to cut costs to offset the rise in burden rates. This will typically be frustrated by the mix changing within the remaining internal production: the high-volume parts will be the ones that look more advantageous to outsource, leaving more and more low-volume parts. External suppliers will be quoting more for low-volume work; they don’t want to run it if they don’t have to either. These parts need more attention, more machine setups, more room to store on average, driving up true “burden rates” per machine hour.
We often recommend that the denominator of standard hours be fixed from year to year for make vs. buy analyses at what could be termed, “if kept busy” volumes. This will eliminate the death spiral because it does not penalize the internal production for any current volume-related inefficiencies. Finally, when faced with under-utilized machines, the make vs. buy comparisons should at least be neutral or better yet favor the “make” outcome so that volume can be added back to the internal production operations.
Going beyond a simplistic assessment of make vs buy costs will entail that you incorporate the following questions into your analysis:
Do you have a strategic bias towards make or buy? Be sure to consider the long-term strategic plans with respect to vertical integration and installed capacity as this can be a significant tie-breaker beyond the strict cost comparisons. Ideally, your organization has set a long-term target for the mix of internal vs external production; if so, use the make vs. buy process part of the transition towards the desired future state.
Are you comparing total cost of ownership, using all the same costs to your business in each side of the make vs. buy analysis? It is quite common for simplified make vs. buy comparisons to ignore additional management costs related to outside production. Internal costing includes these management costs through overhead absorption (e.g. a fully burdened machining rate of $100/standard hour). It would be a mistake to not also assess the incremental resources required to manage external production. You may find that these costs are nearly identical to what is required to manage internal production.
In addition, external production often has an impact on lead times, responsiveness and/or supply risks. This will manifest itself in higher safety stocks which should be translated into annual carrying costs. Capital investments should be factored into each side of the make vs. buy analysis as well, whether they relate to new equipment required for internal production or tooling and fixturing required by internal and external production.
How similar is this part to those your organization currently runs? The further you stray from what you have done in the past, the more skeptical you should be of your costing system’s estimates. Truly new parts should be accompanied by a variety of one-time costs and/or a realistic ramp-up period where costs are calculated assuming less than full efficiency.
If entering a new arena of production has been deemed a strategic imperative, it may be helpful to calculate the piece price at full efficiency while separating all the start-up costs and initial inefficiencies into a single lump sum that represents the up-front investment. This investment can be subjected to your organizations ROI analysis and thresholds to see if it is justified. The piece price comparisons will also be more apples to apples once the strategic investment has been isolated.
Do you trust your internal costing as a comparison basis? While direct costs can certainly be misestimated, the greater danger comes from how indirect labor and overhead are allocated to arrive at a “burden rate”. Cost accounting attempts to minimize errors in product costing; it will never be precisely correct for all products. Warning signs that the inaccuracies have become so significant that the make vs. buy comparison should be questioned would include things like the following:
- Burden over direct labor ratio too high
- Low-volume parts are as attractive as high-volume under make vs. buy comparisons
- All parts result in make (or all are buys)
- Burden rates have changed significantly in the last year
- Not enough discrimination between cheap and expensive machines.
Understanding the conditions that drive Make vs Buy decisions requires a broader focus than a traditional standard costing method provides. It shouldn’t surprise us, that’s not what standard costing is designed to accomplish. It can, with additional considerations, be used as a part of the needed assessment, as long as other key elements are incorporated into your analysis.
Kevin Carson is a principal with Firefly Consulting. He has spent more than 25 years working with clients on operational excellence, delivering impactful results that cross industries, corporate cultures, and geographies.