Make or Buy Decisions for Orbik
Brief overview of Orbik
Established in 1982, Orbik Electronics Limited has always been in the forefront of innovative design of emergency lighting equipment. The four acre purpose built facility at Aldridge in the West Midlands is registered to BSI for its ISO9001/2000 quality system. Today, Orbik has more than 300 products approved by the BSI, indicating the company’s continued compliance on quality, safety and performance standards. Further, Orbik invests heavily in automatic assembly processes which allow Orbik to offer world class standard of service to all customers. Having said this, Orbik has become the first choice supplier to many leading international lighting companies for their specific lighting needs such as emergency control gear, emergency luminaries, central battery and static inverter systems.
Product categories unique to Orbik are fire range and lighting range. In the former, conventional fire alarms, two-wire conventional fire alarms, specialist conventional fire alarms, analogue addressable fire alarms and call systems are on the product list. On the latter, products include luminaries, legends and photometric data, self contained emergency gear, low voltage emergency lighting, addressable emergency lighting systems and electronically controlled emergency lighting. Moreover, Orbik is backed by Relux which made possible the offering of the most technically advanced and user friendly lighting design software.
Purchasing division of Orbik
Considerably, there is a unit that deals with the necessary procurement activities to facilitate production. One of the key responsibilities of Orbik’s purchasing department is to ensure that there will be no shortages. Such responsibility is carried out by properly coordinating acquisition of goods and services and by encouraging open and competitive bidding on all goods and services. When purchasing equipment, materials and supplies as well as services, there is the necessity to ensure that the right quality, in the right quantity at the right price and from the right source is evident.
Banning (1997, p. 1) also noted that the purchasing department takes a new function today wherein the emphasis is on long-term business strategy and less emphasis on the more mechanical tasks of price comparisons and order placement. This premise is particularly true since the modern purchasing department is more often involved in the process of locating new sources, marketing and research and development. Having said this, the purchasing division of Orbik, through the make or buy review team, will determine the criticality of outsourcing versus internal manufacturing.
As a member of the review team, I was tasked to determine the importance of make or buy decisions for Orbik. A purchasing analysis will be conducted through determining the various groups that purchasing must involve with as well as commercial networking and business relationships available for Orbik, and recommend course of actions based on the analysis.
Context diagram
Required for Orbik is to determine whether to outsource or internally manufacture a motor assembly. This is critical considering that it will perform and monitor a core function for a new product line.
Make or buy decisions for Orbik
Orbik has the choice of outsourcing the motor assembly or manufacturing it. There are two apparent concepts: outsourcing versus insourcing. Outsourcing is the process whereby internal functions are contracted out to external providers (Domberger, 1998, p. 12). Insourcing is the direct opposite of outsourcing which means the delegation of operations or jobs from production within a business to an internal unit which specializes in that operation. Amiti and Wei (2004) claim that insourcing is a business decision that aims to maintain control of critical production or competencies.
Based on these definitions, both outsourcing and insourcing could impose various benefits and risks to Orbik and its operation. As it is in the operational level, Orbik, through the make or buy review team, has to weigh these benefits and detriments. Basically, there are cost considerations. If outsourcing would be less expensive or more expensive but with more returns, then outsourcing will be a choice. This is also true considering that all the costs will be vested on Orbik when the motor assembly is insourced such as direct labor, overhead, managerial and materials among others. To compare, outsourcing will cost Orbik in terms of purchase price of motor assembly, transportation, receiving and inspection and follow-on costs on quality and service.
Nonetheless, outsourcing could address the weakness of Orbik and that is lack of expertise and hence could exploit suppliers’ research and specialized know-how. Likewise, outsourcing addresses another dilemma of limited production facilities and insufficient capacity. There are also considerations, further, that Orbik could relay to suppliers’ such as procurement and inventory and managerial control. Orbik also has the freedom to multi-outsource while also diligently choosing from which to outsource from. We should take note, however, that what we are going to outsource is an essential process to Orbiks’s strategy and that is motor assembly. Commonly outsourced are those processes that are not critical to the operations of the company. This could address, nonetheless, by tight, transparent contracts between Orbik and the supplier(s).
Thirdly, deciding to outsource take into full consideration of the many risks that accompanies its benefits. Steven Bragg maintained that “companies will be more likely to outsource a function if there are multiple reasons for doing so” (2006). Such multiple reasons are as follows: a) acquire new skills and better management, b) enhance controls, c) focus on strategy and core functions, d) avoid major investments, e) assist a fast-growth situation, f) handle overflow situations and g) improve flexibility and ratio. Skills inadequacy results in minimal improvements. A way to overcome such problem is transferring of specific functions to highly-competent, well-trained and experienced specialists. Further, a viable option to eliminate poor management in exchange of quality management is through outsourcing of functional areas into suppliers. Through this process, a relative degree of pressure will also be alleviated. The result would be sufficient control over the operation. The tactical part of function-distribution would enable the management to focus on strategy-related issues like market positioning and product development in return while also avoiding heavy investments. Moreover, acquiring increased market share requires a support mechanism for function overloads. Converting fixed costs into variable costs as well as driving the performance ratios improved the profitability per person and the business as a whole (pp. 2-4).
Finally, while there are many benefits for outsourcing, there are also risks including: a) future changes in supplier circumstances, b) perceived risk lower than actual, c) local responsibility, d) supplier failure, e) loss of confidential information and f) loss of jobs. Changes in the operations of suppliers (e.g. financial difficulties, technology requirements of services) might alter the outsourcing relationship. Nonetheless, the risk can be diminished through inclusion of termination clause in contracts. The bandwagon effects of outsourcing are inclined to success to stories whereas, in reality, outsourcing is problematic and conflict-laden. Failures of the suppliers, in effect, are equated to failure of the company are serious risks, not to mention, confidential information sent by the businesses adds up to the constraints since suppliers are given the right and control over crucial informations. Outsourcing a function also means abolishing specific internal jobs while also putting the outsourced workers jobs at risk if the outsourcing did not work (pp. 8-10).
On the other hand, insourcing could benefit Orbik of productive use of the facilities and the manpower. Aside from having a direct control over the production as well as lead time, transportation, and warehousing costs, Orbik will also have the direct control of the quality of the produce. When Orbik decides to change the process for a better lean manufacturing process, it would be easy for the company to integrate plant operations. Overall, however, insourcing has inherent technical and operational issues that may exacerbate costs issues.
Importance of make or buy decisions
The question now is: why is it important for Orbik to determine make or buy decisions? The make-or-buy decision is the act of making a strategic choice between producing an item internally (in-house) or buying it externally (from an outside supplier). The buy side of the decision also is referred to as outsourcing. Make-or-buy decisions usually arise when a firm that has developed a product or part—or significantly modified a product or part—is having trouble with current suppliers, or has diminishing capacity or changing demand.
Make-or-buy analysis is conducted at the strategic and operational level. Obviously, the strategic level is the more long-range of the two. Variables considered at the strategic level include analysis of the future, as well as the current environment. Issues like government regulation, competing firms, and market trends all have a strategic impact on the make-or-buy decision. Of course, firms should make items that reinforce or are in-line with their core competencies. These are areas in which the firm is strongest and which give the firm a competitive advantage.
The increased existence of firms that utilize the concept of lean manufacturing has prompted an increase in outsourcing. Manufacturers are tending to purchase subassemblies rather than piece parts, and are outsourcing activities ranging from logistics to administrative services. In their 2003 book World Class Supply Management, David Burt, Donald Dobler, and Stephen Starling present a rule of thumb for out-sourcing. It prescribes that a firm outsource all items that do not fit one of the following three categories: (1) the item is critical to the success of the product, including customer perception of important product attributes; (2) the item requires specialized design and manufacturing skills or equipment, and the number of capable and reliable suppliers is extremely limited; and (3) the item fits well within the firm’s core competencies, or within those the firm must develop to fulfill future plans. Items that fit under one of these three categories are considered strategic in nature and should be produced internally if at all possible.
Make-or-buy decisions also occur at the operational level. Analysis in separate texts by Burt, Dobler, and Starling, as well as Joel Wisner, G. Keong Leong, and Keah-Choon Tan, suggest these considerations that favor making a part in-house:
- Cost considerations (less expensive to make the part)
- Desire to integrate plant operations
- Productive use of excess plant capacity to help absorb fixed overhead (using existing idle capacity)
- Need to exert direct control over production and/or quality
- Better quality control
- Design secrecy is required to protect proprietary technology
- Unreliable suppliers
- No competent suppliers
- Desire to maintain a stable workforce (in periods of declining sales)
- Quantity too small to interest a supplier
- Control of lead time, transportation, and warehousing costs
- Greater assurance of continual supply
- Provision of a second source
- Political, social or environmental reasons (union pressure)
- Emotion (e.g., pride)
Factors that may influence firms to buy a part externally include:
- Lack of expertise
- Suppliers’ research and specialized know-how exceeds that of the buyer
- cost considerations (less expensive to buy the item)
- Small-volume requirements
- Limited production facilities or insufficient capacity
- Desire to maintain a multiple-source policy
- Indirect managerial control considerations
- Procurement and inventory considerations
- Brand preference
- Item not essential to the firm’s strategy
The two most important factors to consider in a make-or-buy decision are cost and the availability of production capacity. Burt, Dobler, and Starling warn that “no other factor is subject to more varied interpretation and to greater misunderstanding” Cost considerations should include all relevant costs and be long-term in nature. Obviously, the buying firm will compare production and purchase costs. Burt, Dobler, and Starling provide the major elements included in this comparison. Elements of the “make” analysis include:
- Incremental inventory-carrying costs
- Direct labor costs
- Incremental factory overhead costs
- Delivered purchased material costs
- Incremental managerial costs
- Any follow-on costs stemming from quality and related problems
- Incremental purchasing costs
- Incremental capital costs
Cost considerations for the “buy” analysis include:
- Purchase price of the part
- Transportation costs
- Receiving and inspection costs
- Incremental purchasing costs
- Any follow-on costs related to quality or service
One will note that six of the costs to consider are incremental. By definition, incremental costs would not be incurred if the part were purchased from an outside source. If a firm does not currently have the capacity to make the part, incremental costs will include variable costs plus the full portion of fixed overhead allocable to the part’s manufacture. If the firm has excess capacity that can be used to produce the part in question, only the variable overhead caused by production of the parts are considered incremental. That is, fixed costs, under conditions of sufficient idle capacity, are not incremental and should not be considered as part of the cost to make the part.
While cost is seldom the only criterion used in a make-or-buy decision, simple break-even analysis can be an effective way to quickly surmise the cost implications within a decision. Suppose that a firm can purchase equipment for in-house use for 0,000 and produce the needed parts for each. Alternatively, a supplier could produce and ship the part for each. Ignoring the cost of negotiating a contract with the supplier, the simple break-even point could easily be computed:
0,000 + Q = Q
0,000 = Q − Q
0,000 = Q
50,000 = Q
Therefore, it would be more cost effective for a firm to buy the part if demand is less than 50,000 units, and make the part if demand exceeds 50,000 units. However, if the firm had enough idle capacity to produce the parts, the fixed cost of 0,000 would not be incurred (meaning it is not an incremental cost), making the prospect of making the part too cost efficient to ignore.
Stanley Gardiner and John Blackstone’s 1991 paper in the International Journal of Purchasing and Materials Management presented the contribution-per-constraint-minute (CPCM) method of make-or-buy analysis, which makes the decision based on the theory of constraints. They also used this approach to determine the maximum permissible component price (MPCP) that a buyer should pay when outsourcing. In 2005 Jaydeep Balakrishnan and Chun Hung Cheng noted that Gardiner and Blackstone’s method did not guarantee a best solution for a complicated make-or-buy problem. Therefore, they offer an updated, enhanced approach using spreadsheets with built-in liner programming (LP) capability to provide “what if” analyses to encourage efforts toward finding an optimal solution.
Firms have started to realize the importance of the make-or-buy decision to overall manufacturing strategy and the implication it can have for employment levels, asset levels, and core competencies. In response to this, some firms have adopted total cost of ownership (TCO) procedures for incorporating non-price considerations into the make-or-buy decision.
References
Amiti, M. & Wei, S. J. (2004). Fear of Service Outsourcing: Is it Justified? International Monetary Fund.
Banning, K. B. (1997). Opportunities in Purchasing Career, McGraw-Hill Professional.
Domberger, S. (1998). The Contracting Organization: A Strategic Guide to Outsourcing. Oxford University Press.
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