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How to Use Cost Modeling to Evaluate Make vs Buy Decisions

by Edward Pretzel, President Collaborative Supply Chains Posted on 2022-07-29

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Make vs buy decisions are often made with too little information with the predicted benefits soon gone after implementation.  The biggest challenge with making strategic make vs buy decisions is the lack of good data to truly know what is the best long term decision.

We have been involved in numerous strategic make vs buy analysis and decisions.  During these projects we have learned the devious things that both the internal factories and supplier’s factories do to move or keep the business in their direction.

Internal factories are motivated to show lower cost structures to prove and ensure their continued survival.  Sometime we have seen these internal factories only apply variable costs to the costing of parts.  Variable costs include only material, direct labor and the variable portion of factory overhead (mostly utilities).  They exclude the fixed costs of the factory overheads.  The justification of only costing for variable costs and ignoring the fixed costs, is that fixed costs are already being paid for by the current business and therefore can be ignored.  This is strategy is false over the medium term and only true for some short amount of time.  Over time the current business will be reduced as new parts and programs launch in the future.  Therefore you should always apply fixed and variable costs when performing evaluations.  Every part should have to carry its own fixed and variable costs.

Internal factories often will cost without profit.  This is also a bad practice as the internal factory should be required to provide a ROI (return on investment) or profit.  Sometimes the ROI is considered the savings the internal factory provides vs the outside suppliers.  This is acceptable.  But we still recommend that the factory apply a minimum amount of profit, 5-10% of the price.

Suppliers can also do similar devious things that the internal factories to make themselves look better than what they really are.  When suppliers quote on a strategic package of business that represents the potential of eliminating their “internal competitor”, they get aggressive with costs and prices.  If the supplier knows that they are being considered to replace the customer’s internal factory, then the supplier is motivated to only recognize the variable costs and to reduce the profit to near zero.  They do this knowing that they will have pricing power in the future, once the internal factory is shut down.  Then the supplier can raise their costs, profits and prices.

Cost Modeling can identify these devious and manipulative scenarios.  Cost modeling will enable the following:

  • Make transparent the costs and cost drivers including profit
  • Allow for apples to apples benchmarking between the make vs buy factories
  • Will help identify when factories are manipulating the costs and prices to make themselves look better than reality
  • Will help ensure that the make vs buy analysis is true and the decisions can be made with confidence for the long term 
  • It is important to have an independent third party performing the cost modeling, benchmarking and analysis.  Typically this analysis is at an executive level, often requested by the C-suite management team.

Over the years working on numerous make vs buy studies, we have found that either make or buy scenario can be successful.  There are some predictors of success.

Success with the “Make” scenario is often defined by well managed factories that are running with 2-3 shift scenarios.  Running factories at 3 shifts, 5-6 days will spread the fixed costs over more production.  Also, if the parts are produced in the same factory that uses the parts, there is a significant advantage in reduced handling, transportation and reduced inventory.

Success with “Buy” scenarios are common when the buy-factory can utilize raw material more efficiently, the buy-factory is highly utilized, has more automation and more capabilities so as to reduce outsourced secondary processes such as machining, heat treat, painting, etc..  

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