Make or Buy? Recognizing All the Costs

The make-or-buy decision process, while fundamentally the same as it has always been, is far more involved and complex than it was in simpler times past. Manufacturers have greater insight into the many factors that go into the cost to buy a part or a product, and an increased awareness of the some of the less obvious costs. Product costing on the “make” side can be more complete and accurate as well, but the real changes are evident on the “buy” side of the equation.

All procurement professionals are familiar with the concept of landed cost – the actual cost to bring a purchased product to your receiving dock including the actual cost of the product, shipping and transportation, duties and taxes, and other costs that might appear on invoices from the supplier or any of the supply chain service providers involved. That part is quite straightforward. What isn’t so easy is to gather and apply the less direct costs of procurement.

Companies have long struggled with the concept of procurement cost. It is one of the critical factors in the traditional Economic Order Quantity (EOQ) formula that has been around for more than half a century. EOQ tries to balance the inventory carrying cost (also a difficult number to determine) against ordering cost to determine the order quantity that delivers the lowest overall cost. In theory, it’s simply a matter of adding up all of the costs involved and divide by the number of POs issued. The problem is two-fold; many of these costs are buried in either Overhead, or General and Administrative (G&A) and difficult to break out by themselves. The other issue is the assumption that every purchase order consumes the same amount of resources – a ridiculous assumption, but logical alternatives are hard to come by.

A major change in the modern view of procurement costs is recognizing the indirect costs associated with long supply chains. The long transportation lead times and significant transportation expense dictate large order quantities, which in turn demand large inventories (both in-house and in-transit). These large inventories carry with them increased risk of theft, damage, obsolescence, and the aforementioned carrying costs. Large inventories and long lead times also leave the company vulnerable to the effects of changing demand; either having large quantities of un-sellable inventory when demand shifts or decreases, or being out-of-stock for an extended period of time on fast-moving items that are moving even faster than expected.

Perhaps equally challenging is factoring in an allowance for supply chain risk. Recent supply chain disruptions including earthquakes, tsunamis, floods, volcanic eruptions, striking dock workers  and piracy, to name a few, have opened some eyes and made procurement departments more aware of how fragile modern “lean” supply chains can be.

Including these additional costs in the make-or-buy decision process can tip the scales from “buy it from China” to “buy it locally” (or regionally), or perhaps even “make it in-house.” Local or in-house manufacturing may not be a viable alternative if wholesale outsourcing has resulted in the extinction of local production capabilities.

Have you revisited past decisions to outsource?