Lesson 4: Make or buy?

The standard calculation

Brightline buys raw material for a bracket at $5 a unit. Making one takes 15 minutes of direct labour at $10 an hour: $2.50. The overhead factor is 4. So the internal cost is:

$5 material + $2.50 labour + 4 × $2.50 overhead = $17.50 a unit

A vendor offers to supply the bracket for $10. The standard judgment: buy it, and save $7.50 a unit.

Scenario one: the part only uses non-bottlenecks

Most parts only pass through non-bottlenecks.

Brightline outsources the bracket at $10. What really happens to its costs, per unit?

They fall by $7.50, as calculated
They fall by $2.50
They rise by $5

Outsourcing a part usually doesn’t reduce overhead (if anything it rises: more purchasing, more quality checks). It usually doesn’t reduce direct labour either: the people are moved to other work, and still paid. The only tangible saving is the raw material, $5. Brightline now pays $10 to save $5: costs go up by $5 a unit, not down by $7.50.

Scenario two: the part uses the bottleneck

There is no third scenario. When at least one operation on the part is done by the bottleneck, the standard judgment often prevents outsourcing that would be very profitable. Here is how Ruth walked Helen through it.

Ruth: “When the bottleneck is involved, don’t look at cost savings. Look at additional sales.”

Helen: “How?”

Ruth: “First, two facts about the company. Sales are $10 million a year, and raw material is about half the selling price.”

Helen: “Fine, but I don’t see what that has to do with one part. I expected you to ask what it costs us to make.”

Ruth: “Let’s look at the load it puts on the bottleneck instead. Suppose we make 1,000 of these a year, and they take 3% of the bottleneck’s capacity. What happens if we buy all 1,000 outside?”

Helen: “We free 3% of the bottleneck.”

Ruth: “And the bottleneck is what limits our sales.”

Helen: “So sales can grow by 3%: $300,000 a year.”

Ruth: “Careful. Those are sales, not profit. To make them we buy more material.”

Helen: “Half of the price, so $150,000. That still leaves $150,000 a year. That would justify almost any price for the part.”

Ruth: “Let’s finish anyway. Assume an outrageous price: $30 a unit.”

Helen: “1,000 at $30 is $30,000. But we stop buying the $5 of material for those parts, so the net cost is $25,000 a year.”

Ruth: “So the effect on profit is?”

Helen: “$300,000 more sales, minus $150,000 more material, minus $25,000 net for outsourcing: $125,000 a year. And our make-or-buy rule would have said: never pay $30 for something that costs $17.50 to make.”

Pause and think: why did Ruth ask about sales and material, but never about overhead?

Overhead doesn’t change with the decision; sales, material and price do
Because overhead is too hard to calculate accurately for a single part
Because the bottleneck has no overhead

A decision changes the company’s profit only through what it actually changes. Allocated overhead is spent either way.

The pattern

Like the machine, the make-or-buy judgment fails in both directions:

It outsources parts that use only non-bottlenecks, raising real costs.
It keeps in-house parts that use the bottleneck, forgoing large gains.

In both cases, the error comes from the same place: the allocated cost. Lesson 7 shows what to ask instead.

Check your understanding

Answer all five. Get four right to complete the lesson.

1. The bracket’s calculated internal cost of $17.50 includes…

Only raw material
$5 material, $2.50 labour and $10 allocated overhead
The vendor’s margin and the cost of transport
Transport

Overhead factor 4 × $2.50 labour = $10.

2. Outsourcing a non-bottleneck part at $10 really…

Saves $7.50
Saves $10
Costs nothing
Costs $5 a unit more

Only the $5 of material is really saved.

3. When a part uses the bottleneck, outsourcing should be judged by…

The additional sales the freed capacity allows
The part’s cost
The vendor’s reputation for quality and delivery
Labour saved

The bottleneck limits sales.

4. Freeing 3% of the bottleneck at Brightline adds sales of…

$30,000
$150,000
$300,000
$3 million

3% of $10 million.

5. Even at $30 a part, outsourcing added to profit…

Nothing
$125,000 a year
$300,000 a year
$25,000 a year

300,000 − 150,000 − 25,000.