The Make or Buy Decision

I have been asked this question a fair amount of times so I am going to write about it in this blog. The make or buy decision can be a complicated one but in the kaizen/kaikaku life we make it much simpler.
One of the key decisions a company will face (strategically and at the operations level) is what to make in house and what to purchase (buy).
Factors to consider in a make or buy decision include cost, time, capacity utilization, control of production/quality, design secrecy, supplier reliability and technical expertise, volume, and workforce stability.
I think its best to use a concrete, real life, example of a business I worked with in the past.
 Original Data:  Produce 10,000 units
  Cost Factors:    Raw Materials $9,000
                           Direct Labor   $12,000
         Variable factory overhead $5,000
           Fixed factory overhead   $24,000
    Total Cost to Make:    $50,000
Now it is best to break this figure down into price per unit for comparison purposes.
        $50,000/10,000 = $5.00 a unit
The price to purchase is $4.50 a unit
The question is should you buy it or purchase it?
On its face the answer is easy. Purchase it for a saving of $.50 a unit! But hold on!! There are some factors you need to consider.
1. You only avoid 80% of the variable factory overhead costs.
2. You only avoid 10% of the fixed factory overhead costs.  
So now what?
Solution:
Total Cost to make:                        $50,000
Less cost avoided:
                                Raw Material $9,000
                                Direct Labor  $12,000
 Variable Overhead (5,000*.80) = $4,000
 Fixed Overhead (24,000*0.10) = $2,400
Total Avoided Cost:                =$27,400
Cost Not Avoided:                    = $22,600
Plus Cost to Purchase                = $45,000
Total Cost To Purchase        =  $67,600         
   Compare this to the cost to make at $50,000
So, the increase in cost to purchase would be 17,600! or 67500/10000 = $6.75/unit!

The winner is Make it!!! If you don't you will lose $1.75 per unit!

The major thing in the make or buy decision is what are the avoided costs? However, if a company has
poor vendor relationships or trying to keep product secrecy, than the decision becomes much more qualitative.

Computing the numbers is a good baseline for the decision but it should never be based on numbers alone. Time to customer, quality controls, supplier reliability, and workforce stability can all nullify the $1.75 savings.
To illustrate this point, remember the true saying that it costs 5-10 times more to acquire a customer than to keep one; therefore, customer satisfaction will always be the x factor!

Next Blog:

Baka Yoke, One Piece Flow - Sore Dewa Mata!

Value Engineering/Target and Kaizen Costing

Value Engineering is a term that is becoming popular today and for good reason. To understand value engineering one must first understand target costing which is a big part of value engineering and can be explained through the equation: Target cost = Target price - Target margin. A very famous engineer by the name of Dr. Preston G. Smith and his colleague Dr. Reinertsen found that more than 50% of eventual product costs are locked in by the time the product arrives to the development team. The amount of influence a person has over the cost of a product decreases exponentially over time. The moral is to start early!!

This is true in everyday life as well. We all know the phrase, "you can’t teach an old dog new tricks!" The humans character is 50% locked in by the time their development starts, due to their genetic make-up. Through knowledge and understanding of one's predisposed triggers, change happens. Just because one has a genetic disposition to become an alcoholic does not mean they will be. It is through understanding all functions of the human psychos that we can change pre-disposed harmful conditions. If a person knows the reason they have certain thoughts or urges they will have a better chance at changing those unconscious triggers.
In industrial engineering we fix these all too common business failing concepts of "if you make it, they will buy it" through obtaining knowledge through value engineering. Value engineering in short, breaks down every component to its core and keeps only the parts that are integral to functionality, safety, or what a customer will pay for. A company can have a basic, step-up, and premium addition, but everything must be appropriated.
Value Engineering:  A discipline for determining costs of a product and its subsystems, based on value to the customer or user, i.e. no. durability tests, mean time between failures, etc.
            Value Index = Worth to customer/Cost to me
There are many types of techniques to use but my favorite is the weighted matrix (if you’re interested in how to calculate the function-subsystem matrix contact me).
Target Costing: A disciplined process for determining and realizing a total cost at which a proposed product with specified functionality must be produced to generate the desired profitability at its anticipated selling price in the future.There is a four step process to target costing that includes: defining the product, setting the target, achieving the target, and maintaining competitive costs.
Kaizen Costing: Focuses on continuous reduction of costs, which should be realized for existing products in a company. For example, continuously finding ways to reduce non value adding cost drivers like deferred deliveries, wrong deliveries, late deliveries, transportation time, cycle times, while increasing first pass yield (throughput yield) etc.  Remember: Small rain drops will eventually make an ocean!
Kaizen Costing is used after Target Costing and Value Analysis take place. Its a way of improving an already established/controlled process.
It is important to note that in value engineering the market dictates the price of a product not the other way around. In short, a simple cost-plus approach is a recipe for failure, while giving the customer more that they are willing to pay for is a recipe for insolvency.
For example, if I have an electric razor and the technology exists to install a transistor radio in the razor, to listen to music while shaving, should I install it? Will a customer pay extra for this option?
 My body can take 12 beers in a sitting but should I down all 12 beers or will the law of diminishing returns come into play after three or four (depending on alcohol content)?
 If you have any questions or comments, please let me know

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The Make or Buy Decision (popular question)- Sore Dewa Mata!