IPSCMI Monthly Newsletter 2011-4, May 15, 2011
Make or Buy Analysis
By Dr. LeRoy H. Graw, CPSM, CPP, CPPM, C.P.M., CPCM, CISCM, CIPTC
Make-or-Buy analysis is one of the most important functions facing every organization today. It has moved beyond the conventional manufacturing environment into all organizations, both public and private, and now incorporates the analysis of services capable of being performed by either in-house employees or contractors. Make-or-Buy has many additional names, including “outsourcing analysis”, “commercial-industrial activities analysis” (a Federal Government term), and “privatization analysis” (a public sector term). Make-or-Buy analysis of services is considered a world class activity. Unfortunately, there are very few organizations that qualify as “world-class”.
Make-or-Buy is thought of as having five distinct steps or procedures;
a.Determining feasibility. Is is possible for the organization to perform the services? Does the organization have the necessary equipment or facilities to perform the services? Is this the type of service that must be performed in-house because of management policy, exigency, or other reason?
b.Determining need. Can the service be performed more effectively by the organization or by outside contractors?
c.Methods/Processes. How can the organization determine whether the service can be performed less expensively in-house than by a contractor? What are the incremental, relevant costs for both of these options?
d.Analysis of Cost. All cost components must be analyzed, including direct labor and material costs, energy costs, transportation costs, quality costs, capital costs, overhead costs, and General and Administrative costs. (However, only those costs which are relevant and incremental should be considered in the decision).
e.Break-Even Analysis. This is part of "Cost-Volume-Profit Analysis". It attempts to answer the question: "At what volume of service/performance does the service become economical".
Cost volume profit analysis (CVP analysis) is one of the most powerful tools that managers have at their command. It helps them understand the interrelationship between cost, volume, and profit in an organization by focusing on interactions among the following elements:
- Prices of products/services
- Volume or level of activity
- Per unit variable cost
- Total fixed cost
Cost-volume-profit (CVP) analysis expands the use of information provided by breakeven analysis. A critical part of CVP analysis is the point where total revenues equal total costs (both fixed and variable costs). At this breakeven point (BEP), a company will experience no income or loss. This BEP can be an initial examination that precedes more detailed CVP analysis.
Cost-volume-profit analysis employs the same basic assumptions as in breakeven analysis. The assumptions underlying CVP analysis are:
The behavior of both costs and revenues is linear throughout the relevant range of activity. (This assumption precludes the concept of volume discounts on either purchased materials or sales.) Costs can be classified accurately as either fixed or variable. Changes in activity are the only factors that affect costs. All units produced are sold (there is no ending finished goods inventory).
From a management perspective, service outsourcing requires the organization to develop answers to a number of critical questions:
a.Does the organization have an established procedure for conduct of service make-or-buy analysis, with organizational roles and responsibilities assigned? (If not, it will need to develop one specifically for this service).
b.Does Top Management consider this service to be a "core" business function, thus inappropriate for contracting out?
c.Are these services currently performed by employees who are Union members? (If so, the Union Agreement may have provisions limiting the ability to contract out for these services).
d.Are there reasons other than the above which would cause Top Management to insist upon in-house performance? (Such as Cost not "Material" or "Insignificant", for "Political" Considerations, or for "Socioeconomic" Considerations.)
e.Has the cost of this service/function been compared with the cost of contract performance anytime within the last 3 years?
f.Has the cost comparison been audited/reviewed by either the organization's accounting department or by an independent CPA? (If so, there may not be a need to do a cost comparison at this time).
g.Does the service/function in question have "Mission and Functions" Statements, Policies and Procedures, and Job Descriptions for the services? (If not, the process of developing a Scope/Statement of Work for bidding may be complicated).
h.Has the organization contracted for these services at any time in the past? (If so, the Scope/Statement of Work and other contract documentation may be available as guidance for new contracting efforts).
i.Is the organization's cost comparison policy based on preparing estimates of both in-house and contract performance? (If this is policy, is there a method of ascertaining estimate validity/fairness)?
j.Is the organization's cost comparison policy based on an estimate of in-house cost versus "informational quotations" from contractors? (If this is policy, is there a method for validating the in-house estimate to assure it contains a full allocation of relevant indirect costs and further of assuring that the contractor and in-house statements of work are identical)?
k.Is the organization's cost comparison policy based on "head-on-head" competition between the in-house "bid" and firm quotations from contractors? (If this is policy, is there a method for assuring the same issues as for j above?) NOTE: This is normally the best cost comparison method!!
l.Does the organization have a cost differential that it requires contractors to beat before determining to contract out? (If so, does the contractor community know what this differential is)?
m.Does the organization have a means of detecting a "buy-in" in order to avoid awarding to a firm that will reduce performance in order to stay within the bid price?
n.Does the organization have the staff to adequately administer the service contract? (Can some of the existing in-house staff be "converted" to contract administrators)?
o.Does the organization have a plan for reduction in force and/or reassignment of existing in-house staff?
p.Does the organization have terms and conditions appropriate to service contracting? (Normal "Supply" terms will not suffice)!!
q.Does the organization have a review and analysis system that will assure "lessons learned" from one analysis are carried forwarded into future analyses?
r.Does the organization view outsourcing as a business tool or a goal unto itself?
A number of criteria or factors typically drive the outsourcing decision:
a.Cost. A thorough and accurate cost analysis is a basic part of any decision to outsource. This analysis must consider all the relevant and incremental costs of performing the service by contract and in-house.
b.Technology. Outside suppliers may be able to offer an organization more advanced approaches and procedures than those currently in use by the organization.
c.Investment. When a decision to contract out a service currently being performed in-house is being considered, the organization will need to include plans for the current facilities. Is there a function for the equipment that will no longer be used? Is there a market for it? Can the vacated space be used in a more productive manner?
d.Service Level. Part of any decision to outsource should be the ability to respond better to customer needs. If the outsourcing of a service will help the organization be more flexible, it should be considered.
e.Differentiation. Private contractors are often more creative in performing the needed services than in-house staff.
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If you want to hone your cost management skills further, you might consider one of more of the basic or advanced online courses available from IPSCMI at A cost oriented program that puts you right at “the State of the Art”, is “Cost and Value Management”.
At the completion of this course, students will be able to:
- Learn how cost management methods and practices are used to help a firm succeed.
- Apply appropriate cost management methods in planning and decision-making, preparation of financial and management reports, and management and operational control.
- Explain how Total Cost of Ownership can be used by a purchasing and supply chain management organization to increase the value of the organization’s products and services.
- Explain how value (cost) engineering and target costing is used in the design stage of a product to create value for a product.
- Explain how value (cost) analysis is used after the design stage of a product to increase the value for a product.
- Explain how value (price) analysis is used by a buyer as a method of price analysis in order to determine the better/best value among competing products.
- Explain how net present value analysis is used to determine which capital investment projects should be funded and supported by the organization.
- Explain how earned value analysis is used to track cost expenditures in a project.
You might be interested in other IPSCMI courses which can be found at A course dealing specifically with Cost/Volume/Profit Analysis is Cost and Price Analysis.
These four week courses (and many other basic and advanced purchasing and supply chain courses) are available for a very reasonable $220 tuition per course.
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