Great post as always. I go through this way too fast in my Intro Supply Chain class, but they get the point (it’s strategic and complicated).
For example…Let’s pretend you are a junior buyer. Suppose that a make-buy decision is being made for an injection molded plastic part. In other words, do you make it yourself or do you outsource it to a supplier?
The fixed costs of making this part are $200,000. The variable cost to make this part is $0.40. The lowest bid received from the pool of qualified suppliers is $0.75 per part. What is the break-even quantity? Hint: It is the point where the total cost to manufacture equals the total cost to purchase. The information in the comments section might help. Interpret your results. Meaning, what decision should you make based on if you need more or less than the break-even quantity?
Two purposes for a break-even analysis:
1) Determine if production volume is sufficient for a firm to produce a given product
2) Estimate break-even sales level for a supplier to determine how eager they are for new business
To determine the break-even point for the make/buy decision, three pieces of information are required:
1) The fixed costs of producing the product
2) The variable costs of producing the product
3) The purchase price per unit
To calculate the break-even quantity – A graph can be plotted by:
Setting up the graph with total cost as the vertical axis and # of units as the horizontal axis.
Plotting the purchase cost line, which starts at the origin with slope equal to the per unit purchase cost.
Plotting the make cost line, which starts at quantity zero with a total cost equal to the fixed cost, and has a slope equal to the variable cost.
The intersection is the break-even point. Do not do it this way.
Use algebra in the Make/Buy example above.
It is the point where the total cost to manufacture equals the total cost to purchase. Letting Q be the break-even quantity, we can calculate this as:
200,000 + 0.40Q = 0.75Q
And, with a little algebra
Q = x
So if the company plans to use more than x of these parts, it is cheaper to make them (in general, ignoring a host of other cost issues). So if the company plans to use less than x of these parts, it is cheaper to buy them (in general, ignoring a host of other cost issues).
This exercise assumes that the Make/Buy decision is based on cost issues and nothing else. We know that the sourcing decision should be based on more than just cost. Other factors influencing the Make/Buy Decision such as: availability of multiple sources, spares, capacity, need for direct control over production or quality, design secrecy, supplier reliability. The Make/Buy decision is a strategic issue because your decision could impact your firm for years to come.
The make or buy decision should be a part of the firm’s strategy development process.
Costs: All relevant costs must be…see comments –