CHAPTER FIVE

OUTSOURCING
Chapter objectives
To describe strategic issues under outsourcing
To discuss influencing make or buy decision
Introduction
Firms may use one of the two methods to get raw
materials. One is making. Making is manufacturing the
raw material that is necessary to produce one item.
The second is buying. It is procuring the necessary raw
material from suppliers in order to produce an item.
Outsourcing :is contracting with another company or
person to do a particular function. It is a practice used
by different companies to reduce costs by transferring
portion of work to outside suppliers rather than
completing internally.
It is a practice in which an individual or company
performs tasks, provides service or manufacture some
parts for another company.
Cont’d…
Almost all organizations outsource in some way.
Typically the function being outsourced is considered
noncore to the business. E.g. insurance company may
outsource its janitorial and landscaping operation to
firms that specialize in those types of work.
Reasons for outsourcing save overhead and labor
costs, greater productivity and efficiency due to focus
on core products and functions of a business.
 When a firm considers which components or
subsystems it should make and which it should buy, it
should analyze the issue at two levels; i.e. strategic and
operational(tactical) level.
5.1 Strategic
The Issues
starting under
point mostSourcing
firms use in conducting the strategic
analysis is to identify the major strengths of the firm and
then build on them, what is it we really do well- better than
most firms?
Do our strengths lie in certain design skills, unique production
skills and equipment, different types of people skills? A
thorough investigation of these types of questions is what
many people today call identifying the firm’s existing core
competencies.
The next step in the process is to look at the current and
expected future environment in which the firm operates; i.e.
the competition, the governmental regulatory climate, the
changing characteristics of sales and supply markets, and so
on.
In considering what to make and what to buy, then, the
decision should cultivate and exploit the firm’s competencies.
Cont’d…
The items that should be made in house are those that
require capabilities that are closely linked with the
core competencies and are mutually reinforcing as
opposed to those that can be separated.
This fundamental strategic consideration guides the
original make or buys decisions that ultimately shape
the character of the firm.
If the analysis to this point indicates that “make”
decision is desirable from a strategic point of view,
before the decision is made several additional factors
must be analyzed.
These practical considerations focus on a comparison
of the firm’s present situation with that of potential
suppliers with respect to the matters of design,
manufacturing, and quality capabilities.
  After
5.2 theDecisions
Tactical strategic “make” and outsourcing decisions are finalized,
and as operation progress, a number of situations inevitably arise
that require additional make or buy analyses at something less than
a strategic level.
 Unsatisfactory supplier performance in the case of some outsourced
items,
 Changing sales demands,
 Restricted manufacturing capacity and
 The modifications of an existing product
these are just a few the operating factors that generate needs.
 As a rule, from a “make” prospective these tactical make or buy
situations involves items for which the firm already possesses most
of the necessary production resources.
 Although the decision requiring a nominal expenditure of funds
does not require direct top- management participation, it does
require coordinated study by several operating departments, i.e.
perhaps using a team approach.
 1. Cost consideration (less expensive to make or to buy the
5.3 Factors Influencing Make or Buy Decisions
parts):
 In some cases, cost considerations indicate that a part should be
made in home; in other, they indicate that it should be purchased
externally.
 A make or buy cost analysis involves a determinations of the cost to
make an item and a comparison of this cost with the cost to buy it.
 To make the item, the firms will incur delivered purchased material
cost, direct labor cost, any follow-on costs stemming from quality
and related problems, incremental inventory carrying costs, and
incremental factory overhead cost, etc.
 And also, if the firm wants to buy the similar item, the firm will
incur costs related to purchasing price, transportation cost,
receiving and inspection costs, incremental purchasing costs and
any follow-on costs related to quality or service.
 To see the comparative cost picture clearly, the analyst must
carefully evaluate these costs, considering the effects of time and
capacity utilization in the user’s plant.
Cont’d…
i. The time factor: - cost can be computed on either a
short- term or a long –term basis. Short- term
calculations tend to focus on direct measurable costs; i.e.
they frequently understate tooling costs and overlook
such indirect material costs as those incurred in storage,
purchasing, inspection and similar activities.
 Moreover, a short-term cost analysis fails to consider the
probable future changes in relative cost of labor,
materials, transportation, and so on.
Cost figures must include all relevant costs, direct and
indirect, and they must reflect the effect of anticipated
cost changes. It thus, becomes clear that in comparing
the costs to make and to buy, the long- term view is the
correct one.
cont’d…
ii. The capacity utilization factor:- the root of the
problem lies in the user’s capacity utilization factor.
• An analyst should be guided by several basic ideas.
First, incremental costs are virtually always the costs
germane to the managerial decision making process.
• Second, the determination of a realistic cost to make
an item requires realistic estimate of the future
conditions of capacity.
Cont’d…
2. Control of production and/or quality
 Production requirement: - the need for close control of production
operations is particularly acute in some firms. A company whose sales
demand is subject to extreme short-run fluctuation finds that its
production department must operate on unusually tight time schedules.
 Some firms also choose to make certain critical parts to assure continuity
of supply of these parts to succeeding production operations.
 Quality requirement: - unique quality requirements frequently
represent a second condition requiring control of part production
operations. Certain parts in technical products are occasionally quite
difficult to manufacture.
 Compounding the difficult, at time is a usually exacting quality
specification the part must meet. A user normally understands more
completely than outside supplier the operational intricacies connected
with usage of the part.
 Therefore, if using firm makes the part itself, there can be greater
conditions b/n the assembly operation and the part production operation.
Cont’d…
3. Design secrecy required
Although their number is small, a few firms make particular
parts primarily b/c they want to keep secret certain aspects of
the part’s design or manufacture.
The secrecy justification for making an item can be found in
highly competitive industries where style and cost play
unusually important role.
4. Unreliable suppliers
A few firms decide to make specific parts because their
experience has show that the reliability record of available
suppliers falls below –the required level.
Regardless of the reasonableness of the cause, however,
consistently unreliable performance by a supplier is sufficient
grounds for shifting – suppliers or possibly reconsidering
Cont’d…
5. Suppliers’ specialized knowledge and research
A primary reason underlying most decisions to buy a part
rather than make it is the user’s desire to take advantage of
the specialized abilities and research efforts of various
suppliers.
6. Small- volume requirement
When a firm uses only a small quantity of a particular item,
it usually decides to buy the item. The work of designing,
tooling, planning and setting up for the production of a new
–part is time-consuming and costly to firms.
The small- volume user consequently, searches for a
potential supplier who specializes in production of the given
part and can economically produce it in large quantities.
Such specialty suppliers can sell to a large number of users
in almost any desired quantity at relatively low prices.
Cont’d…
7. Limited facilities
A firm with limited facilities typically attempts to utilize them as
fully as possible on its most profitable production work. It then
depends on external suppliers for the balance of its
requirements.
8. Work force stability
A fluctuating production level compels a firm to force the
continual problem of contracting and expanding its work force
to keep in step with production demands.
Significant continuing fluctuation, moreover, adversely affects
the quality of workers such a firm is able to employ. The less
stable an operation, the more difficult it becomes to retain a
competent work force.
9. Multiple source policy
Some firms occasionally make and buy the same nonstandard
part. This policy is followed for the explicit purpose of having
available a reliable and experienced second source policy.

Cont’d…
10. Managerial control consideration
 Companies occasionally buy and make the same part for the purpose of
developing managerial control data. Some firms use outside suppliers’ cost and
quality performance as a check on their own internal production efficiency.
 If internal costs for particular part rise above supplier’s cost, the user knows
that somewhere in its own production system some element of cost is probably
out of tine.
 11. Procurement and inventory considerations
 A “buy “decision produces several significant benefits in the management of
purchasing and inventory activities. For purchasing, such a decision typically
means that it has fewer items to buy and fewer suppliers to deal with.
 Usually, though not always, when a component is made in-house a number of
different materials or parts must be purchased to support the “make” operation.
 The buy decision usually involves only one or two suppliers and relative
reduction in the associated buying, paper work, and follow-up activities.
 The some relative reduction in workload is passed on to the receiving,
inspection, stores, and inventory management groups. Inventory investment is
also reduced.
Cont’d…
12. Administration of make or buy decision
It is not difficult to find otherwise well-managed firms
in which many tactical make or buy decisions are
inadvertently delegated to an operating person in
inventory control or production control. It should now
be apparent that this is a poor practice b/c:
First, such person normally does not have adequate
information with which to make an intelligent
decision for a companywide point of view.
Second, even if adequate information were available
this type of person typically lacks the breadth of
experience to evaluate fully the significance of the
information and the resultant decision.
Cont’d…
In most cases, make or buy decisions should be made, or at
least reviewed, at a managerial level. The decision maker
must be able view such problems with a broad companywide
perspective.
Many progressive firms use a team or committee approach to
analyze make or buy alternatives. The important point to
keep in mind is that all departments that can contribute to
the decision, or that affected by it, should have some voice in
making it. A team or committee accomplishes this directly.
In addition to providing and operational framework within
which make or buy alternatives are investigated, a review
system is necessary. The system should provide:
 The entry of project into the study system
 Maintenance of essential records and
 A periodic audit of important decisions
Thank you