Chapter 3_st - Make or Buy Decisions.pptx

Procurement

1. Chapter 3 Make or Buy Decisions

2. Agenda Purchasing Decisions Qualitative Method for Making or Buying Decision Quantitative Method for Making or Buying Decision Outsourcing issues

3. 1. Purchasing Decisions Insourcing: Insourcing deals with past buy decisions that are reversed. E.g. ““We would prefer not to produce this product or service in-house, but we really don’t have any other options.” Outsourcing : buying materials and components from suppliers instead of making them in-house. The trend has moved toward outsourcing. Subcontracting : subcontracts can exist only when there are prime contractors who bid out to other contractors Application: when placing orders for work that is , will take a long period of time, and will be extremely costly. The subcontract management team: a subcontract administrator (SCA), an equipment engineer, a quality assurance representative, a reliability engineer, a material price/cost analyst, a program office representative, and/or an on-site representative. The SCA must maintain , , , and from the beginning to the completion of the task. 3

4. Purchasing Decisions (cont.) Should we Change the way we currently take make or buy decisions? Consider insourcing more? Outsource more? How can we Improve our ability to find insourcing opportunities? Develop our outsourcing expertise better? Should we work with single or multiple supplier(s)? What supplier should we select/reject? How to evaluate correctly suppliers? Should we outsource some components? 4

5. Make or Buy and Insourcing or Outsourcing Decisions

6. 2. Qualitative Method

7. Reasons for Buying or Outsourcing Cost advantage: Especially for components that are to the organization’s operations. Insufficient capacity: A firm may be at or near capacity. Lack of expertise: Firm may not have the necessary technology and expertise. Quality: Suppliers have technology, process, skilled labor, and the advantage of economy of scale. Risk: reduce of new product development, low volume output. Technology: Obtain technical or management ability 7

8. Why Buy?

9. Reasons for Making Protect proprietary technology No competent supplier Better quality control Use existing idle capacity Control of transportation and warehousing cost Lower production cost Utilize surplus labor and make a marginal contribution 9

10. Why Make?

11. The Outsourcing Decision Is the activity strategic? (gives the firm its competitive edge over competitors) Is this activity critical to the business but not strategic? Create a Request for Proposal. Gather several supplier bids/ proposals Is the supplier’s bid/proposal more desirable ( in terms of Costs/Resources/Finances) than the internal function bid? Could the internal function achieve similar results without Supplier assistance? Negotiate a contract to ensure that expectations are realized Keep the function in-house Y N Keep the function in-house Keep the function in-house Keep the function in-house Y N Y N N Y

12. 3. Quantitative Method

13. The Make-or-Buy Break-Even Analysis

14. Economic Order Quantity-EOQ Q = Quantity in a lot or batch size D = Demand per unit time. S = Cost per order placed or setup cost, ($/order) C = Unit cost = average price/unit purchased($/unit) i = Carrying “interest” rate (%/year) Q = Order size (units) H = Holding/Carrying cost = hC ($/unit/year) N = Number of orders per year h = fraction of the unit cost of the product.

15. Optimal order size = ? Common trade-off: low fixed cost at nearby shop, small lot-size and high fixed cost of far shop, large lot-size  Total cost= holding cost + fixed cost + buying cost  TC = ( Q /2) H + ( D / Q) S + DC Inventory Holding Cost Cost of Capital Obsolescence (or spoilage) cost: value of the stored product drops because its market value or quality falls Handling cost: receiving/storage costs Occupancy cost: change in space cost due to changing cycle inventory Miscellaneous costs: theft, security, damage, tax, insurance… Ordering Cost: Buyer time, placing order, Transportation costs, Receiving costs, and Other costs,…

16. Optimal Order Size = ? Holding cost Ordering cost Total Cost Q *

17. Economic Order Quantity-EOQ  

18. Example The store S has observed a stable monthly demand for its line of mobile phone iPhone of 100 pcs per month. The store incurs a fixed cost of $2,000 every time it places an order for additional iPhones. The store pays $200 per iPhone. The store’s out-of-pocket costs of storing a iPhone for a year are about 10% and the opportunity cost of capital is 15%. What order size do you recommend for the S store? 18

19. Solution D = 1200 pcs/ year, S = $2,000 / order, H = (0.15 + 0.10) 200 = $50 /pcs/ year  Q* = SQRT(2*1200*2000/50) = 309.8  round to Q* = 310 N = 1200/310 = 3.9 orders/year Order every 365/3.9 = 94 days Total cost: TC(Q*) = S  (D/Q*) + H  (Q*/2) = 2000  (1200/310) + 50  (310/2) = $7,745 + $7,745 = $15,492 / year

20. Insights from EOQ Formula Fixed Cost Reduction: Leads to smaller orders/batches Sales growth: Suppose sales quadruple Average inventory only doubles Centralization of inventory: Suppose four equal sizes hospitals “pool” their inventories Total inventory cut in half

21. Economic Production Quantity (EPQ) Notations: C: unit production cost ($/pcs) i : interest rate (%) S: production setup cost ($) H: inventory holding cost ($) h: percent of holding cost in C production Cost (%) W: total number of annual working days (days/year) D: annual demand (pcs) t: time between orders Q: Order quantity TC: Total costs

22. EPQ In production, the entire lot does not arrive at the same time because production has a rate of P. Inventory builds up at a rate of (P-D) when the production is on and inventory is depleted at a rate of D when production is off  Economic Production Quantity - EPQ In practice, the reorder point would be set at some inventory level above zero to notify production that supplies soon would be needed The replenishment period , t , is the length of the time required to produce the economic production quantity, EPQ: Maximum inventory level = (P-D)t =(P-D)(Q/P) =(1-D/P)Q Then, the average inventory level =(1-D/P)(Q/2)  

23. EPQ Total annual EPQ Cost = Where: S = setup cost C = production cost This leads to:  

24. Example One product produced by BB is a doll. It has a fairly constant demand of 40,000 per year. The soft plastic body is the same for all the dolls, but the clothing is changed periodically to conform to fad hysterics. Production runs for different products require changing the molds and settings of plastic-forming machines, new patterns for the cutters and sewers, and some adjustments in the assembly area. The production rate of previous runs has averaged 2000 dolls per day. Setup costs are estimated at $350 per production run. A doll that sells for $2.50 at a retail outlet is valued at $0.90 when it comes off the production line. Complete carrying costs for production items are set at 20% of the production cost and are based on the average inventory level 24

25. Solution EPQ = 13,146 with annual P = 2000 dolls/day x 200 days/year Number or batches (production orders/year) = D/EPQ = 40,000/13,146 = 3 Production time to run 1 batch, t = EPQ/P= 13,146/2000 = 6.6 days Maximum inventory level = (1 – D/P)EPQ = (1 – 40,000/400,000)(13,146) = 11,831

26. Make or Buy Decision Using EOQ and EPQ calculation results, DM decides to make or buy. For example, buying price of the product is $50/pcs. If product is produce, its production rate is 20,000 pcs/year at production cost of $44/pcs. However, if buying, ordering cost is $10 while production setup cost is $100. Annual demand is 5,000 pcs/year with holding cost is $10/pcs. Interest rate is 15%.

27. Make or Buy Decision (cont.) If buying, total annual cost is: If making, total annual cost is: Conclusion: Manufacturing  

28. Practice A product is bought at $25/pcs or production at a rate of 10,000 pcs/year at production cost of $23. If buying, ordering cost is $5, while production setup cost is $50. Annual demand is 2,500 pcs and holding cost is at 10%. Should we buy or product that product ourselves?

29. 4. Outsourcing Issues Information channels: unclear/unstable/ less communicative requirements. Technology, manufacturing capability is limited. Price and contract are not good to control the output. Material supply Transportation Payment Delivery, commissioning: time, results/finished goods. Samples, defective rate,…

30. Strategic Risks Create new competitor(s): 1914 – The Dodge Brothers has changed from Ford’s engine supplier to its direct competitor. Japan electronic appliance industry: starting to be subcontractors for American companies in the area of supplying radio devices. Lose control to the supplier(s) IBM subcontracted with Microsoft and Intel for CPU and Operating System. They join to create “Window Machine” and “Intel Inside” Lose control channel to customers “Own brand” program of supermarkets