Make v. Buy: Considerations when Outsourcing to Reduce Cost

June 1, 2005
By Darren Dolcemascolo

The decision to outsource a part or assembly is often based on lack of internal resources, refocus of core competencies, or cost reduction. The focus of this article is on outsourcing with the objective of lower cost. If you are attempting to outsource a part or assembly that is produced in-house based on lower cost, you must perform a thorough analysis. In many cases, cost can only be reduced if the supplier is going to use a more efficient process or significantly less expensive labor. You must be careful in comparing costs. Because standard cost includes fixed costs, comparing standard cost with the prices being quoted is not an “apples to apples” comparison. Unless you are going to eliminate some fixed costs, the only real cost reduction is the variable cost. If the supplier cannot produce the part for a price lower than your variable cost, you are not saving your company money.

If you are in the process of outsourcing a part or assembly in an effort to reduce cost, you should be searching for a supplier that can produce the part using a more efficient method than you (or a much lower labor rate) are currently using. This might allow them to produce the part faster and/or at a lower labor cost than you can produce the part. Even after they add in their overhead and profit, it is possible that the supplier can produce the part for less cost than you can in house.

Usually, organizations compare the standard cost as determined by cost accounting with the price a supplier is quoting in making a make/buy decision. This is almost always fallacious. The standard cost includes fixed costs that will continue to be part of operations whether the product is manufactured in-house or not. In many cases, the supplier’s cost will be lower than the in-house standard cost; however, the reality is that overall company costs and the costs of other products will increase if this part is outsourced; this is because fixed costs will be spread over a smaller number of units after a part is outsourced. The exception to this would be if a company shut down a portion of its operations (reduced fixed costs) and considered outsourcing an entire manufacturing operation; in this case, it could eliminate a portion of its fixed cost and possibly have a lower product cost. Detailed analysis would need to be performed to determine if this is the case.

Consider the following example. XYZ Company produces many of their machined parts in-house. XYZ’s materials manager has been tasked with reducing product cost. He begins with part A since it is the highest volume part and has the highest potential for cost reduction. Part A has a standard cost of $2,300. The variable cost component (labor and material) is $1,200. The fixed cost component (overhead including machine tools, building, etc.) is $1,100. A supplier quotes the part at $1,800. Because XYZ produces 3,000 of these per year, the materials manager believes he is saving the company $1.5M per year by outsourcing this part. This apparent savings is shown in Table 1, but the savings is not real. The only real cost reduction is the variable cost reduction in this case. The company has reduced its cost by $1,200 per part but the savings is offset by a $1,800 per part cost to the supplier. XYZ is operating at a higher cost by outsourcing this part. XYZ has increased its costs by $1.8M per year; however, in XYZ’s ERP system, the standard cost of part A is now lower ($1800 vs. $2300). See table 2. The fact that costs have increased shows itself in the form of higher standard costs for all other parts using the same facilities as part A. This gives the materials manager incentive to outsource more parts thus creating a cycle of increasing standard costs for in-house parts and savings on paper by outsourcing. The underlying reality of higher costs is not obvious except in the company’s bottom line.

Table 1
Standard Costs for Part A In-House After Outsourcing
Labor $1100 $0
Materials $100 $1800
Fixed Costs Allocated $1100 $0
Total Standard Cost $2300 $1800
Apparent Savings per piece   $500
Apparent Annual Savings (3000 pcs per year)   $1.5M

Relevant Costs Annualized In-House After Outsourcing
Labor $3.3M $0
Materials $300K $5.4M
Fixed Costs $3.3M $3.3M
Total $6.9M $8.7M
Actual Additional Cost   $1.8M

Note: Fixed Costs would be allocated to other parts after outsourcing.

To determine if lower costs are possible by outsourcing, one must consider all relevant costs in detail. Factors that will influence whether or not lower costs can be achieved by outsourcing are process and labor costs. If a supplier has a better process for producing the part, it is possible that he can produce it for less than your organization. Also, if a supplier has lower labor costs (such as a supplier in Mexico or China), again it would be possible that he can produce the part at a lower cost. If neither of these is true, one must be skeptical that a lower cost can be achieved by outsourcing. The supplier must have some profit built into their price. Given that fact, if they are using a similar process and are working with the same labor pool that you are, it is unlikely that you will save your organization money simply by outsourcing parts currently manufactured in-house.

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