A daily question faced by managers is whether the right components and services will be available at the right time to ensure that production can occur. Additionally, the inputs must be of the appropriate quality and obtainable at a reasonable price. Traditionally, companies ensured themselves of service and part availability and quality by controlling all functions internally. However, there is a growing trend toward “outsourcing” (buying) a greater percentage of required materials, components, and services.
This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal production and opportunity costs with purchase cost and assesses the best uses of available facilities. Consideration of an in-source (make) option implies that the company has available capacity for that purpose or has considered the cost of obtaining the necessary capacity. Relevant information for this type of decision includes both quantitative and qualitative factors. Here is lists the top motivations for companies to pursue outsourcing.
Top Ten Reasons to Outsource
- Reduce and control operating costs.
- Improve company focus.
- Gain access to world-class capabilities.
- Free internal resources for other purposes.
- Obtain resources not available internally.
- Accelerate reengineering benefits.
- Eliminate a function difficult to manage/out of control.
- Make capital funds available.
- Share risks.
- Obtain cash infusion.
Source: The Outsourcing Institute, Survey of Current and Potential Outsourcing End-Users
And below figure presents factors that should be considered in the outsourcing decision. Several of the quantitative factors, such as incremental direct material and direct labor costs per unit, are known with a high degree of certainty. Other factors, such as the variable overhead per unit and the opportunity cost associated with production facilities, must be estimated. The qualitative factors should be evaluated by more than one individual so personal biases do not cloud valid business judgment.
Outsource Decision Considerations
Relevant Quantitative Factors:
- Incremental production costs for each unit
- Unit cost of purchasing from outside supplier (price less any discounts available plus shipping, etc.)
- Number of available suppliers
- Production capacity available to manufacture components
- Opportunity costs of using facilities for production rather than for other purposes
- Amount of space available for storage
- Costs associated with carrying inventory
- Increase in throughput generated by buying components
Relevant Qualitative Factors:
- Reliability of supply sources
- Ability to control quality of inputs purchased from outside
- Nature of the work to be subcontracted (such as the importance of the part to the whole)
- Impact on customers and markets
- Future bargaining position with supplier(s)
- Perceptions regarding possible future price changes
Although companies may gain the best knowledge, experience, and methodology available in a process through outsourcing, they also lose some degree of control. Thus, company management should carefully evaluate the activities to be outsourced. The pyramid shown below is one model for assessing outsourcing risk.
Factors to consider include whether:
(1) a function is considered critical to the organization’s long-term viability (such as product research and development)
(2) the organization is pursuing a core competency relative to this function; or
(3) issues such as product/service quality, time of delivery, flexibility of use, or reliability of supply cannot be resolved to the company’s satisfaction.
Case Example: Outsource Decision
Here is information about inkjet printers produced by Online Computers. The total cost to manufacture one case is $5.50. The company can purchase the case from a chemical products company for $4.30 per unit. Online Computers’ cost accountant is preparing an analysis to determine if the company should continue making the cases or buy them from the outside supplier.
Production of each case requires a cost outlay of $4.10 per unit for materials, labor, and variable overhead. In addition, $0.50 of the fixed overhead is considered direct product cost because it specifically relates to the manufacture of cases.
This $0.50 is an incremental cost since it could be avoided if cases were not produced. The remaining fixed overhead ($0.90) is not relevant to the outsourcing decision. This amount is a common cost incurred because of general production activity, unassociated with the cost object (cases). Therefore, because this portion of the fixed cost would continue under either alternative, it is not relevant.
The relevant cost for the in-source alternative is $4.60—the cost that would be avoided if the product were not made. This amount should be compared to the $4.30 cost quoted by the supplier under the outsource alternative. Each amount is the incremental cost of making and buying, respectively. All else being equal, management should choose to purchase the cases rather than make them, because $0.30 will be saved on each case that is purchased rather than made. Relevant costs are those costs that are avoidable by choosing one decision alternative over another, regardless of whether they are variable or fixed. In an outsourcing decision, variable production costs are relevant. Fixed production costs are relevant if they can be avoided when production is discontinued.
The opportunity cost of the facilities being used by production is also relevant in this decision. If a company chooses to outsource a product component rather than to make it, an alternative purpose may exist for the facilities now being used for manufacturing. If a more profitable alternative is available, management should consider diverting the capacity to this use.
Assume that Online Computers has an opportunity to rent the physical space now used to produce printer cases for $90,000 per year. If the company produces 600,000 cases annually, there is an opportunity cost of $0.15 per unit ($90,000:600,000 cases) from using, rather than renting, the production space. The existence of this cost makes the outsource alternative even more attractive.
The opportunity cost is added to the production cost since the company is foregoing this amount by choosing to make the cases. Sacrificing potential revenue is as much a relevant cost as is the incurrence of expenses.
The next figure shows calculations relating to this decision on both a per-unit and a total cost basis. Under either format, the comparison indicates that there is a $0.45 per-unit advantage to outsourcing over in-sourcing.
Another opportunity cost associated with in-sourcing is the increased plant throughput that is sacrificed to make a component. Assume that case production uses a resource that has been determined to be a bottleneck in the manufacturing plant. Management calculates that plant throughput can be increased by 1 percent per year on all products if the cases are bought rather than made. Assume this increase in throughput would provide an estimated additional annual contribution margin (with no incremental fixed costs) of $210,000. Dividing this amount by the 600,000 cases currently being produced results in a $0.35 per-unit opportunity cost related to manufacturing. When added to the production costs of $4.60, the relevant cost of manufacturing cases becomes $4.95.
Based on the above information (even without the inclusion of the throughput opportunity cost), Online Computers’ cost accountant should inform company management that it is more economical to outsource cases for $4.30 than to manufacture them. This analysis is the typical starting point of the decision process—determining which alternative is preferred based on the quantitative considerations.
Managers then use judgment to assess the decision’s qualitative aspects. Assume that Online Computers’ purchasing agent read in the newspaper that the supplier being considered was in poor financial condition and there was a high probability of a bankruptcy filing. In this case, management would likely decide to in-source rather than outsource the cases from this supplier. In this instance, quantitative analysis supports the purchase of the units, but qualitative considerations suggest this would not be a wise course of action because the stability of the supplying source is questionable.
This additional consideration also indicates that there are many potential long run effects of a theoretically short-run decision. If Online Computers had stopped case production and rented its production facilities to another firm, and the supplier had then gone bankrupt, the company could be faced with high start-up costs to revitalize its case production process. This was essentially the situation faced by Stonyfield Farm, a New Hampshire-based yogurt company. Stonyfield Farm subcontracted its yogurt production, and one day found its supplier bankrupt—creating an inability to fill customer orders. It took Stonyfield two years to acquire the necessary production capacity and regain market strength.
These costs should be referred to as long-run variable costs because, while they do not vary with volume in the short run, they do vary in the long run. As such, they are relevant for long-run decision making.
For example: assume a part or product is manufactured (rather than outsourced) and the company expects demand for that item to increase in the next few years. At a future time, the company may be faced with a need to expand capacity and incur additional “fixed” capacity costs. These long-run costs would, in turn, theoretically cause product costs to increase because of the need to allocate the new overhead to production. To suggest that products made before capacity is added would cost less than those made afterward is a short-run view. The long-run viewpoint would consider both the current and “long-run” variable costs over the product life cycle. However, many firms expect prices charged by their suppliers to change over time and actively engage in cooperative efforts with their suppliers to control costs and reduce prices.
Outsourcing decisions are not confined to manufacturing entities. Many service organizations must also make these decisions. For example, accounting and law firms must decide whether to prepare and present in-house continuing education programs or to outsource such programs to external organizations or consultants.
Private schools must determine whether to have their own buses or use independent contractors. Doctors investigate the differences in cost, quality of results, and convenience to patients between having blood samples drawn and tested in the office or in an independent lab facility. Outsourcing can include product and process design activities, accounting and legal services, utilities, engineering services, and employee health services.
Outsourcing decisions consider the opportunity costs of facilities. If capacity is occupied in one way, it cannot be used at the same time for another purpose. Limited capacity is only one type of scarce resource that managers need to consider when making decisions.