MDP4330

Production Systems Design

Lecture #3
Make-or-Buy Decisions and Break-
Even Analysis
 Lecture content
1. Make-or-buy analysis
2. Beak-even analysis
3. Application of break-even-analysis to
machine/process selection

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 Make-or-Buy Decisions
• Most products are made up of multiple components, and
production involves many activities or processes.
• An important business decision is whether to produce a component
yourself “in-house” or buy it from another supplier (outsourcing) .
• Issues to be considered while making this decision:
– Quality of the externally procured part
– Reliability of the supplier in terms of both item quality and
delivery times
– Criticality of the considered component for the
performance/quality of the entire product
– Potential for development of new core competencies of
strategic significance to the company
– Existing patents on this item
– Costs of deploying and operating the necessary infrastructure
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 Make or buy
• Reasons to make instead of buy:
1- Small orders or quantity, no supplier want to take it.
2- Quality requirements too high, no supplier can do it.
3- To preserve technological secrets.
4- To obtain lower cost
5- To avoid sole-source dependency.
6- To ensure steady running of the corporation’s own
facilities.
7- Environmental reasons, like competitive, political,
social…
8- To take advantage of low cost labor, equipment

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 Make or buy

• Considerations which favor buying

1. Suppliers’ research and specialized know-how
2. Cost considerations (less expensive to buy)
3. Limited production facilities
4. Desire to maintain a stable work force (in
periods of rising sales)
5. Desire to maintain a multiple-source policy

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 Make-or-buy analysis
• Cost considerations:
– In some cases cost considerations
indicate that a part should be made in-
house; in others, they indicate that it
should be purchased externally.
– A make-or-buy cost analysis involves a
determination of the cost to make an
item, and a comparison of this cost with
the cost to buy it.

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Make-or-by decisions based on economic
measures
Can the item No
Be MAKE
Purchased?

Yes

Can we make No
BUY
the item?

Yes

Is it cheaper No
BUY
for us to make?

Yes

Yes Is there enough No

MAKE BUY
capital to make?
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 Make-or-buy analysis
• Cost elements in the MAKE decision:
1. Delivered purchased material costs
2. Direct labor costs
3. Inventory carrying costs
4. Factory overhead costs
5. Any follow-on costs stemming from quality and
related problems

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 Make-or-buy analysis
• Cost elements in the BUY decision:
1. Purchase price of the part
2. Transportation costs
3. Receiving and inspection costs
4. Incremental purchasing costs
5. Any follow-on costs related to quality or service.

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 Make-or-buy analysis
• Generally, in the make alternative, variable
and fixed costs are included.
• However, for the buy alternative, there is
generally no fixed cost; only the variable
costs are calculated by the buyer.
• The break-even-analysis (BEA) can be used
here to guide the make or by decision.

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 Break-Even Analysis (BEA)

• Study of
interrelationships $’s TC
among a firm’s sales,
costs, and operating TR
profit at various levels
of output
• Break-even point is
the Q where TR = TC Profit
Q
(Q1 to Q2 on graph) Q1 Q2

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 Linear Break-Even Analysis

• Over small enough range of output levels TR and

TC may be linear, assuming
– Constant selling price
– Constant marginal cost
– Firm produces only one product
– No time lags between investment and resulting
revenue stream

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 Graphic Solution Method

• Draw a line through TR

origin with a slope of P $’s
TC
(product price) to
represent TR function VC
• Draw a line that 1 unit Q
intersects vertical axis
at level of fixed cost FC
and has a slope of MC P

• Intersection of TC and 1 unit Q Q

Break-even
TR is break-even point point

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 Algebraic Solution
• Equate total revenue and total cost functions and solve for Q
TR = P x Q
TC = FC + (VC x Q)
TR = TC
P x QB = FC + VC x QB
(P x QB) – (VC x QB) = FC
QB (P – VC) = FC
QB = FC/(P – VC), or in terms of total dollar sales,

PQ = (FCxP)/(P-VC) = ((FCxP)/P)/((P-VC)/P) = FC/((P/P) – (VC/P))

= FC/(1-VC/P)

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 Related Concepts

• Profit contribution = P – VC
– The amount per unit of sale contributed to
fixed costs and profit
• Target volume = (FC + Profit)/(P – VC)
– Output at which a targeted total profit
would be achieved

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 Example – how many Fanous Ramadan
need to be sold

• Wholesale price per fanous is EGP30.00

• Fixed cost is EGP130,000
• Target profit is EGP20,000
• Variable cost per fanous is EGP10.00
• Solution
Target volume = (FC + Profit)/(P – VC)
= (130,000 + 20,000)/(30 - 10)
= 150,000/20 = 7500 “fanouses”

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 BEA for “Make or Buy” problem (no time
value of money)
Model parameters:
• c1 ($/unit): cost per unit when item is outsourced (item price, ordering
and receiving costs)
• C ($): required capital investment in order to support internal
production
• c2 ($/unit): variable production cost for internal production (materials,
labor, variable overhead charges)
• Assume that c2 < c1
• X: total quantity of the item to be outsourced or produced internally
Total cost as c1*X
a function of X
C+c2*X

X
X0 = C / (c1-c2) 17
 Example: Introducing a new (stabilizing)
bracket for an existing product
• Machine capacity available
• Required “infrastructure” for in-house production
– new tooling: $12,500
– Hiring and training an additional worker: $1,000
• Internal variable production (raw material + labor) cost:
$1.12 / unit
• Vendor-quoted price: $1.55 / unit
• Forecasted demand: 10,000 units/year for next 2 years

↠ X0 = (12,500+1,000)/(1.55-1.12) = 31,395 > 20,000

↠ Buy!

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Another example with time value of money

• To make an electronic component part, material can be

purchased for $4.98 per unit, labor costs are $5.60 per unit,
annual operating costs are $2,000 per year, and equipment
costs are $35,000 with salvage value of $4,000 and an
estimated life of 8 years.
• There are 5,000 units required per year of the component
part.
• The desired rate on capital is 20%
• The part can be purchased for $14.50 per unit.
• Determine if the part should be purchased or made in-house.

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 Another example (cont.)
The first step is to estimate the annual fixed cost for the capital investment and
the operating cost. Here, the following cash flow diagram represents the current
investment situation:

$ 4,000

$2,000 per year

$ 35,000

The equivalent uniform annual cost (EUAC) = 35,000 (A/P, n=8, i=20%) + 2,000 –
4,000 (A/F, n=8, i=20%) = $10,879 = fixed cost / year to make

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 Another example (cont.)
Cost to make 5,000 units per year =
5,000($10.58) + $10,879 = $63,779
Cost per unit = $12.76 per unit to make the product

Since the cost of the purchased item is $14.50 per unit, it is less costly to make
the component.

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 BEA – two production methods to
accomplish same task
• Method I : TC1 = FC1 + VC1 x Q
• Method II : TC2 = FC2 + VC2 x Q
• At break-even point:
FC1 + (VC1 x Q) = FC2 + (VC2 x Q)

(VC1 x Q) – (VC2 x Q) = FC2 – FC1

Q x (VC1 – VC2) = FC2 – FC1

Q = (FC2 – FC1)/(VC1 – VC2)

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 Example 1 - bowsaw or chainsaw to cut
Christmas trees

• Bowsaw
– Fixed cost is $5.00
– Variable cost is $0.40 per tree
• Chainsaw
• Fixed cost is $305
• Variable cost is $0.10 per tree
• Solution
Q(break-even) = ($305 - $5)/($0.40 - $0.10)
= 300/.30 = 1,000 trees

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Example 2 – machine/process selection
A prospective kitchen blender manufacturer has a
design that requires hard plastic connecting gears
between the electric motor and the cutting blade
assembly. As shown in next table, there are three
alternatives for obtaining such parts.

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Break-Even Analysis

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