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The production capacity of all organizations is limited by its resources: human, equipment, cash and time. In making decisions about the production of goods and services, you may have to decide between making them yourself, buying them in from another supplier, subcontracting the production to another organization, or outsourcing to another organization.
What to Decide
In deciding whether to make, buy, subcontract or outsource, you should ask yourself the following questions:
- Should the business supply all of its products and services using its internal resources? You need to establish if your organization has the skills and the capacity to do this.
- Could the business buy in certain parts of its production process, e.g. a component part for manufacturing? It could make sense for you to combine your internal resources with those purchased from outside.
- If the organization has limited resources, could its production capacity be better used elsewhere by buying or subcontracting? Your internal resources could be stretched already by existing work – can it cope with any extra demands?
- Can certain functions be outsourced, e.g. inbound customer calls, or HR services? Often it is advisable to outsource certain functions as the cost of maintaining these internally can be high.
The Importance of Opportunity Cost
- Opportunity cost: establishing what has been forgone by choosing one course of action over another.
The concept of opportunity cost is an important consideration when making choices about how best to use limited resources in relation to make, buy or subcontract decisions.
That is, what alternative opportunities is the business giving up by producing all of its products or services from its internal resources, or by subcontracting them to outside organizations, or buying them from a third party?
Let’s consider some examples:
Eng Services Ltd produces drilling equipment for the oil industry. It needs a component part to make one of its products. At the moment, Eng Ltd has spare capacity and can make the part internally for £15.00 per unit. A subcontractor whom the company has approached can sell the same part to Eng Ltd for £20.00.
Decision: Eng Ltd should make the part internally, since the variable cost of subcontracting is an extra £5.00.
Assume that Eng Ltd has no spare capacity. It can only produce the part internally by reducing the production of another of its product lines. While it is making each of the parts, it will lose £12.00 per unit from its other product.
Decision: Eng Ltd should subcontract, based on the following breakdown of information:
£
Cost of production of the part
15
Oppotunity cost of lost production of the other product
12
TOTAL COST
27
As the cost of £27.00 incurred by producing the part internally is more than the £20.00 per part paid to the subcontractor, the company should buy, not make.
Think About the Following …
Organizations should undertake make, buy, subcontracting or outsourcing decisions on the basis that there is a measurable benefit, i.e. that cost savings will be made.
However, there are other issues that are equally important which will impact on these decisions:
- Do you have the necessary skills and expertise to make or supply all of your products and services from your internal resources? If so, then establish why you’re considering buying, subcontracting or outsourcing. Is it because, for example, buying the product in is cheaper? Or it can be supplied quicker than you can make it, and it is necessary to keep to a time scale? If the answer to these questions is no, then there is likely to be little reason not to go for the internal option.
- Do you want to have total control over each stage of your production process? Going externally can mean a loss of control, unless you have measures in place. Establish the time scales to get the work finished and insist on regular updates. Agree a process that will allow you to monitor and evaluate their output.
- How dependent will you become on outside suppliers? This is an important point – what if something happens to them and they can’t provide what you need? Always ensure you have contingency measures in place in case your external organization lets you down.
- Can you protect yourselves from the risk of supplier price increases? Obtain a few quotes for various organizations to see who is offering the best value. Agree a price with them upfront. Always check your budget to ensure you can afford the cost.
- Would subcontracting have an adverse effect on quality? Ask to see samples of the external companies’ work, and also references from existing customers. Agree the quality of work you expect, and stipulate that if the work falls below this standard then the organization will be expected to redo it within agreed time scales or to refund some of the cost.
- What do your customers think of your outsourcing? As your customers are the ones who will ultimately buy your product or service, it is important to consider what they think. If you establish that you might lose customers as a result, what will the loss be to your organization? If it’s more than the saving you will make from outsourcing, then it might not be worth it.
