Science and the second renaissance of Europe

Science and the second renaissance of Europe

56 Long Range Planning Vol. 12 December 1979 A Strategic Perspective for Make or Buy Decisions Lawrence R. [such* and-Harold K. Wilson* Make ...

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56

Long Range Planning

Vol. 12

December

1979

A Strategic Perspective for Make or Buy Decisions Lawrence

R. [such* and-Harold

K.

Wilson*

Make or buy decisions have typically been relegated to purchasing departments. While this is not totally unjustified, top management must consider the strategic implications. In essence, operative decisions are made here which influence the strategic thrust of the organization. Make or buy decisions have substantial strategic implications in the entire planning process. They can affect a firm’s competitive advantage, and alter the types of alternatives considered in the planning process. It is argued that strategic considerations should outweigh technical and conventional approaches to make or buy decisions. Top management needs to put these decisions back on their strategic agenda.

Prescriptions for improving the make or buy decision have been well documented from a variety of economic and quantitative viewpoints. For instance, Levy and Sarnat’ discuss the impact of this decision on various components of cash flows, and the differential risks associated with it. Gross2g3 and Hubler4 outline various accounting procedures which will aid in achieving economical procurement policies. Raunick and Fisher5 provide a model whereby prcbabilistic components can be incorporated into the make or buy decision. Production Management texts (such as B~f%a)~ argue for basic policies which place solely economic criteria in the driver’s seat with respect to deciding on whether to make or buy components for production. More recently, Uyar and Schoenfield7 propose a sophisticated mathematical approach to the make-buy decision. However, the preponderance of literature regarding the make or buy decision fails to consider the impact of the techniques and the decision outcome on the firm’s basic strategy. Judging from a review of professional literature available on the subject, it appears that this particular set of decisions has either been ignored by top management, or evaluated, then placed exclusively in the realm of proare urged to rely heavily on curement departments -who data provided by cost accountants-on the assumption that once made, the decision will remain correct for all time. We do not deny that economic criteria and hard ‘Lawrence R. Jauch is Associate Professor and Harold K. Wilson is Assistant Professor at Southern Illinois University, Carbondale, III 62901, U.S.A.

data need to be quantitatively analyzed. However, it appears that top managers have relegated a strategic decision to the purchasing department by their failure ro re-examine or monitor their original make or buy decision. Giving up this important decision by default can limit the strategic alternatives available and place the firm in the position of suboptimizing their position along a less desirable strategic path. This paper considers these strategic aspects of the make or buy decision and advocates the restoration of the decision to top management levels as part of the ongoing strategic assessment and decision process. Some would argue that our criticism of the economic thrust of make or buy decisions is unfounded. Gross,“.3 for example, discusses a variety of quantitative and qualitative factors to be analyzed by growing firms. Leveya discusses how a human relations approach is a relevant considerarion in Polaroid’s make-buy decisions. Marleys suggests that the decision is more than just a matter of cost comparisons. And the Management Accounting Practices subcommittee of the National Association of Accountantslo emphasized that nonfinancial considerations might possibly be of such significance as to outweigh purely financial evaluations. Uxar and Schoenfeld7 even recognize that noneconomic rattors should be taken into account before attempting to apply quantitative models. As an example, at PhilcoFord, with plants in Brazil, Argentina, Mexico, Taiwan, and the U.S., there is a recognition that a number of factors are involved. To quote a top executive, ‘You have to justify the “make” investment and t!iis can be done in a number of ways. It may be a question of better quality. It may hinge on improved scheduling control. Or, in some cases, it may even depend on what your long range plans for the future are.’ (Ptrrchasirzg, 1974.j11 Unfortunately, while it appears that the tendency is to encourage recognition of these factors, the prescription is still to specify that the decision itself be grounded in quantifiable analyses which ignore major strategic questions. As a recent survey reported, 80 per cent of the make or buy decisions are being made by purchasing managers alone. l2 And the majority of these purchasers made this decision principally on the basis of price to

A Strategic

for Make or Buy Decisions

Competitive Advantages All firms need some competitive advantage to survive and effectively accomplish objectives.15 Some firms excel with good products, others with good marketing strategies, others are known for technical expertise, etc. The make or buy point of view can be related to these internal strengths or weaknesses in the following ways.

The Strategic Connection Since our thesis revolves around the fact that make or buy is a strategic question, this position needs to be examined.

1. Product/Market Stratqies Some enterprises attempt to compete by finding their differential advantage through such factors as pricing, quality, quick delivery, or completeness of product lines. Making or buying components, or even whole products, could affect each of these approaches to a competitive advantage.‘”

Figure 1 provides a framework within which to explore the impact of make or buy decisions on strategic planning. It should be noted that strategic decisions flow from decision makers’ attempts to satisfy objectives while considering how best to use the firms’ competitive advantages to meet environmental contingencies.

For instance, the decision tc buy components may alter prices a firm will charge for its product. Similarly, product quality will be affected by such a decision. For

or buy phase,

Product, Markets Financial Resources

-Product/Service Mix

Plants and Equipment

-Market

-Supplier Conditions - Socio-economic Conditions

Niche

-Market

Conditions

Technology Personnel

Retrenchment

Manufacturing Policy Marketing Policy Personnel Policy Organization Policy

A : Feedback

Outcome Evaluation

and ---___~~------~

“Adapted from William F. Glueck, Business Policy: Strategy (New York: McGraw Hilli,

Figure

1. A model

of strategic

planning

57

these decisions rightfully belong in the strategic analysis phase because they involve theLinteraction between the firm and its environment. We will now examine how these decisions should be an integral part of strategic choices flowing from environmental and internal corporate conditions.

buy versus cost to make. Even in firms with make or buy committees, they are often guided in their decisions by corporate make or buy manuals that set specific procedures.13 While perhaps these can work effectively, in many cases, the decision to make or buy involves a basic strategy question which requires regular review in addition to the cost analysis. Skinner’* notes, ‘policies and procedures developed at lower levels reflect assumptions about strategy which are often incorrect or misconstrued’. We contend that many ofthese decisions should be the responsibility of the management group, not committees of operative line managers or individual purchasing managers.

While traditionally, by default or design, make decisions are relegated to the implementation

Perspective

Formulation

to

I Entire Process I andManagement

Action

58

Long Range Planning Vol. 12

December 1979

example, a firm may feel it can control quality better by making the product from start to finish itself. Conversely, others feei by buying certain parts or products, a speciaiist manufacturer can maintain better quality. Regardless which of these is true in the particular instance, if quality is an integral part of a firm’s competitive advantage, the quality outcome of a decision to make or buy needs to be considered. In the same way, if quick delivery is an integral part of the firm’s strategy, consideration must be given to the vagaries of supply reliability versus the control obtained by making the product in-house. For instance, in 1976 Video Logic Corp. of Sunnyvale, California, had a problem getting a reliable supply of springs. Volume was so low they were unable to exert pressure on the supplier. Now they purchase spring steel and produce a 6 month supply in a half-hour rather than an 8 to 12 week wait for delivery. Similarly, Thorsen Tool Company, Dallas, Texas, has been growing faster than their suppliers and has installed screw machines to produce their own screws rather than extend lead times to 6 months. If the firm’s advantage obtains from having a complete line of products, consideration must be given to obtaining this line from internal capabilities or from buying certain products to round out the line. Additions to the product line obviously require a make or buy decision from the start. (It is interesting to note that Square D Company in Raleigh, North Carolina, seeks to design all products so they can be made or bought. Obviously, this allows for future strategic flexibility.) Of course, part of *this consideration is dependent on other firm capabilities (financial, technical and production capabiiities to be discussed below), and supply factors. Nevertheless, these important strategic questions regarding development of competitive advantages from the product/market segment of the firm are affected by, and may influence decisions with respect to purchasing or making the product itself. 2. Financial Resources Businesses may be blessed with advantages (or cursed with disadvantages) flowing from their financial condition. There are, obviously, differential capital needs with respect to making vs buying, Similarly, cash flows can be significantly altered when comparing a decision to make or to buy. Firms with an advantage of strong capital or cash flow positions, may take a far different strategic posture with respect to making or buying than their rivals. For instance, during periods of rapid growth, firms limited by a weak capital or cash flow position may not be able to expand manufacturing capabilities, and are forced to a buy position. In the United States, Monsanto has preferred to place money down-stream rather than in materials. They feel they get more return this way for their investment dollar. Related here is the notion that the returns from ‘value-added’ is a strategic question of some significance. As Buckhout17 notes, ‘When cost of capital is low, firms should re-evaluate make-buy decisions in preparation for future increase in demand’.

3. Plant and Equipment For some firms, part of their competitive advantage rests with their excellence in designing and developing more efficient manufacturing practices and processes. For instance, at Maytag, the make or buy decision is wide open because the company has a broad array of manufacturing equipment. And at General Electric, expecting steel wire to become scarce, they have redesigned two air conditioner parts at their Tyler, Texas manufacturing plant. The grill, which was made of steel wire, is now made of injection-molded plastic. From a strategic perspective, firms with these advantages may choose to take advantage of this by maximizing output. On the other hand, it is not uncommon to find a firm which develops a competitive edge through their ability to provide rapid delivery on short and difficult manufacturing tasks. Often, their success is rewarded with larger orders from faithful customers who expect the same rapid delivery. Faced with these demands but unwilling or unable to expand to meet these demands, the firm may seek to resolve their dilemma by seeking an alternate source for a portion of their market demandthe firm faces a strategic make or buy problem. Firms deciding to make rather than buy, may emphasize long runs at lower cost, but could lose customers who previously relied on them for quick delivery. Conversely, firms which set up for short runs and quick service may lose an advantage if demand increases beyond plant and equipment limitations. This, again, may force a make or buy decision of strategic importance in terms of satisfying market and customer use of plant and equipment with make or buy implications of tradeoffs between e&ciency through specialization or retaining goodwill. 4. Technology Firms whose competitive edge lies in research and development expertise can also be related to the strategic make or buy decision. For instance, excellence in developing new products or processes would most naturally lead to a decision to make rather than buy. But, a company could choose to assign patents, or share knowledge such that suppliers or others could provide them with the results of their own development. A recent example is E. I. duPont deNemonrs and Company and Atlantic Richfield Company. They are developing a joint refinery project to assure a petrochemical supply for duPont and increase Atlantic’s refinery capacity. Quite obviously, if a decision is made to make rather than buy technically sophisticated components or products, then the firm must have, or develop, this kind of expertise. 5. Personnel, Management and Organization Enterprises with advantages in their ability to attract and hold personnel may have a strategic advantage vi+ &is make or buy. For instance, changes in capabilities or composition of management or the workforce may allow a make decision (if proper skills are present), or force a buy decision (if these skills are absent). Ultimately, managerial philosophy and strategic choices will, sooner or later, affect decisions to make or buy (e.g.

A Strategic Perspective for Make or Buy Decisions a philosophy of specializing was made in point one above, which could be a strategic choice of some significance to the make or buy decisions). Finally, if a decision is made to make components or secure new supply sources, new organizational arrangements may be needed to accommodate the change. For instance, International Minerals and Chemicals has strengthened its supply of natural gas for ammonia via a subsidiary’s acquisition of an oil and gas producing company. New organizational arrangements will be needed to accommodate this vertical integration. To summarize, there is much more to consider with respect to internal capabilities to make or buy than questions such as (a) Do we have capacity? (b) Do we have expertise? (c) Can we make it cheaper? A host of strategic issues dealing with the firm’s internal strengths and weaknesses must be addressed as a major input into the strategic make or buy decision. Most of these must be considered at top management levels. However, the planner cannot stop here either, for there are external factors and considerations to be examined as well.

Environmental Opportunities

Threats and

A major element of strategic planning requires monitoring and assessment of external changes occurring in the industry, markets served, supplier segments, government agencies, etc., to see what impact these changes might have on the organization and its strategy. We can look at the major aspects of the environment to suggest how these would affect strategy in connection with a make or buy decision. 1. Supplier Segment

Perhaps the most relevant segment in the strategic environment for the make or buy decision is that of raw material resource providers. This has traditionally been used (in the tradeoff comparison with internal ‘make’ costs) with reference to pricing aspects of major subassemblies or parts purchased. And, of course, changes in availability of major subassemblies, parts, or raw materials is a relevant factor as well. This has been recognized, recently, as becoming much more significant.18 For instance, Dow Chemical is building its own oil refinery in Freeport, Texas, to supply the chemical buildingblocks for thousands of products from anti-freeze to plastic wrap. But we would suggest other inputs into analysis of this environmental segment. For instance, the question of reciprocity might be raised. Do you wish, strategically, to begin competing with a former supplier? MelinlO cites a case where strategic decisions of a Swedish paper company (Holmens Buck AB) were influenced by a ‘social responsibility’ philosophy. The company questioned whether it should build its own large sawmill in view of the fact that it would threaten relationships with suppliers of wood raw materials. More importantly perhaps, what conditions are affecting your suppliers? For example, new technology may affect supplier costs or production capability with respect to the components

59

bought. Technological developments may also affect transportation or delivery of components. Or, major suppliers may be ready to enter or exit that industry. Suppliers may be vulnerable to work stoppages. Similarly, governmental restrictions may be altering the conditions and factors of supply of raw materials, components, or subassemblies. In each of these cases, a potential environmental change needs to be assessed first, in terms of its affect on suppliers or potential suppliers, and second, on how such a change affects your strategy and decision to make or buy. A crucial question to be answered in the make or buy decision, from the strategic perspective is, do we need to reduce our dependence on one or a few suppliers? This can be done, of course, by making, or by buying from additional supply sources. Part of the answer, however, will depend on an environmental assessment of the supplier segment. 2. Other Environmental Factors Several factors were mentioned in connection with their potential affect on suppliers: union activity, governmental regulation, technological change, material availability, competitive activity. These factors and others can affect the firm itself, its strategy, and the make or buy decision. While the foregoing influences on suppliers would influence the decision from the ‘buy’viewpoint, they could affect the ‘make’ viewpoint as well. For instance, a strategy to make subcomponents could result in alleged anti-trust violations ifentry into the field were seen as a significant potential thrust. Thus, potential governmental regulation enters the picture. What competitors of the firm itself are doing with respect to their suppliers can influence the decision to make or buy. (Conceivably, a competitor could make a strategic move to ‘corner’ major supply sources, leaving others dependent on them or their own resources.) In addition to those environmental factors, others can be enumerated. For instance, if consumer ideas about the product are undergoing changes, a need might exist to alter product strategy. This could entail, for example, tightening quality control. One way to implement this is to make the complete product oneself. Community pressures, and managerial reactions to it (from the social responsibility viewpoint), could call for a strategic change involving making a product in order to increase employment levels. While many of these scenarios could be hypothetical, they are not unknown. Clearly, however, environmental threats and opportunities affect suppliers, and the firm itself. What is suggested here, is that in the strategic choice process, and the make or buy decision in particular, elements of environmental change are relevant inputs for managerial consideration.

Strategic Alternatives and Make or Buy Decisions So far we have discussed internal and external conditions which serve to constrain make or buy decision making from the strategic perspective. In this final section, we

60

Long Range

Planning

Vol. 12

December

offer some illustrative strategic alternatives to suggest how and why the make or buy decision appropriately belongs in the realm of top management strategic planning. Top managers make strategic decisions for the purpose of accomplishing objectives, presumably leading to improved performance for the organization. Here we are concerned with non-stability strategies; i.e. those which involve some change in strategy, whether from a growth or retrenchment viewpoint, since a make-or-buy decision point implicitly assumes a posture of change. 1. Growth Straregirs These strategies imply a change in direction involving large incremental adjustments upward in goals, or major mission alterations. Those to be discussed here are product/service line expansions, concentric mergers and vertical integration. A major growth strategy for many organizations is the introduction of new products to their line. The decision to add products is related to the make or buy decision in that some firms may decide to round out a line through buying speciality products, while others decide to make the product addition themselves. An interesting example of how the make or buy decision can affect strategy was recently reported in Electronic News.20 Many electronics firms use in-house designed and controlled test systems. They often do this to avoid the capital acquisition route which requires a lengthy justification to buy a computer controlled test system that uses somebody else’s computer. Many computer firms hold back from the test equipment business so as not to divert energies from general purpose application equipment. However, some firms (such as CDC) are seeking markets for their inhouse designed and used test systems. What we see here is the potential for new products which originally were the result of a ‘make’ decision. Thus, in-house make decisions, while not necessarily strategic in orientation initially, clearly have potential for altering a firm’s strategy.

1979 cal companies are sounding buy decision here is

cries of alarm.

The make or

most important for chemical companies not directly involved in reclaiming natural resources-those firms that neither drill for their own petroleum, dig their own ores nor refine their own oils, For them, backward integration looms as a tremendously expensive alternative to allowing others to fill their requirements.17 Nonetheless, through joint ventures or on their own, some have decided to secure a captive supply. For these firms, the make-buy decision is of strategic importance, and can lead to a major change in the mission of the organization. Interestingly, for other firms, the decision rests with an environmental factor-government restrictions regarding raw materials extraction and use. Interestingly, in these firms, final decisions rest with the chief executive officer or a committee he heads. Considering the strategic importance and capital investments, this is not unexpected. What is instructive, however, is that other make or buy decisions, as mentioned previously, may have similar strategic importance but are treated as procedural and technical in nature. This should be changed. 2. Retrenchment Strategies These strategies are designed to improve performance of the firm bv cost reductions, reduction in functions performed, or cutting products or markets up to, and including, liquidation. Make or buy decisions, of course, can be involved in any of these approaches. What comes first to mind is major cost cutting programs with a goal of improving performance. The traditional make-buy decision revolving around cost tradeoffs is relevant here, of course. But strategic issues are involved as well. For instance, major cutbacks in R & D may Or if capacity cutbacks prevent a ‘make’ decision. affecting product mix loom on the horizon, a decision to buy or make may alter the conclusion. A similar

example lies in the decision to liquidate parts For instance, this could free up capacity to make other kinds of products previously purchased. A number of companies who sold money-losing computer divisions used their freed up resources to make other products.

ofa business.

Another growth strategy entails a concentric technical one with firms very similar in products merger -i.e. and/or technology. In this instance, a make or buy decision could potentially trigger a merger consideration. For instance, if the partners to the merger buy common parts, the merged firm may be in a position to be able to make these parts, where the previously independent firms may not have been able to. Similarly, if one of the firms made parts which the other was buying, a merger provides a different strategic position for both.

Another retrenchment approach is to become a captive company by selling all or most of one’s output to one or a few customers. Under these conditions, the major customer could require the firm to make their own subassemblies, or might specify purchases of components from particular suppliers.

A potential merger with suppliers suggests the third kind of growth strategy-backward vertical integration. In its pure form this strategy is a ‘make’ decision. That is, the firm wished to control its source of supply by ‘making’ its inputs itself. These kinds of make or buy decisions may involve strategic questions of tremendous significance and capital outlay. For example, it has recently been reported that purchasing managers at major chemi-

To summarize, there are strategic implications inherent in make or buy decisions. What may be a good make or buy decision for Company A may be a poor decision for Company B, its competitor, which is pursuing a different strategy. Cost factors are important, but need to be considered as part of the strategy the firm is following in light of its own competitive advantages and environmental conditions.

A Strategic

Make or Buy and Top Management The conclusion we draw from many of these examples regarding the strategic connection to make or buy decisions is that they are too important to be delegated to lower level managers. When make or buy decisions are made at lower managerial levels, the potential is there for the decision to constrain top managers in the choices which are available to them. Prior decisions to make or buy may preclude top management consideration of some strategic alternatives because they altered a competitive advantage, failed to consider an environmental opportunity or threat, or influenced a strategic move contrary to the intent of the executive decision makers. Therefore, managers need to consider the strategic implications of decisions now being made to make or buy; and they need to consider the make or buy implicacations of their strategic decisions. Thus, we encourage a top down approach to these decisions. In this way, managers can hopefully reduce the potential for suboptimality from a strategic perspective. For if the make or buy decision is not viewed straregically, and is made at lower levels in the organization, it is quite possible that the strategy top management assumed was being implemented, will actually become sabotaged (albeit innocently).

61

for Make or Buy Decisions

Reffrences (1) Haim Levy and Marshall Sarnat, The make or buy decision, Journal (1976).

of Genera/

Management,

4 (I),

46-50,

Autumn

(2) Harry Gross, Make or buy decisions in growing firms, The Accounting

Review, 41 (4), 745-753,

October (1966.3).

(3)

Harry Gross, Purchasing procedures for make or buy decisions, Journal of Purchasing, 2 (4). 63-73, November (19666).

(4)

Myron J. Hubler Jr., The make or buy decision, Management Services, 3 (6). 45-51, November-December (1966).

(5)

Donald A. Raunick and Armen G. Fisher, A probabilistic make-buy model, Journal of Purchasing, 8 (I), 63-80, February (1972).

(6)

E. S. Buffa, Modern York (1965).

(7)

Kilvim Uyar and Hanns-Martin Schoenfeld, integrating production scheduling, capacity acquisition, and/or abandonment and make-buy decisions, Management international Review, 13, 99-l 16 (1973/2-3).

(8)

Gary D. Levey, The second .aim, Management 55 (12), 4749, June (1974).

(9)

John Morley, Buy or make: it’s not just a matter of cost comparison, Business, 96 (7), 70-73, July (1966).

Production

Management,

Wiley, New

Accounting,

(10)

National Association of Accountants, MAP committee approves ‘criteria for make-or-buy decisions’, Management Accounting, 56 (3). 58, September (1973).

(11)

Make or buy is many September (1974).

(12)

Peter Wulff, Make-or-buy Purchasing, 73 (6). 83-87,

(13)

Peter Wulff, Make-or-buy : teamwork 67 (12), 27-31,25 December (1969).

(14)

Wickham Skinner, Manufacturing-missing link in corporate strategy, Harvard Business Review, pp. 136-l 65, May-June (1969).

(15)

Robert L. Katz, Management of the Total Enterprise, 142-143, Prentice-Hail, Englewood Cliffs, NJ, (1970).

(16)

Owen Davies, The marketing approach to purchasing, Long Range Planning, 4 (1974).

(17)

Wayne E. Buckhout, Chemical firms mull make-buy decisions, Chemical Marketing Reporter, pp. 1 l-21, 3 May (1976).

(18)

Somerby Dowst, Make or buy : delivery problems can tip the scales, Purchasing, 81 (6). 47-51, 21 September (1976).

Conclusion Strategic considerations should outweigh technical and conventional purchasing decisions. Make or buy factors invoked in the name of ‘cost’ are not irrelevant, but are only one of a multitude of criteria which top managers need to evaluate in their strategic choice process. Purchasing systems and make or buy decisions inevitably involve tradeoffs and compromises. So they must be designed to perform a limited task well, with that task defined by strategic choices and objectives. To do otherwise offers the potential for misguided strategy. Tradeoffs and compromises regarding strategic issues are properl), the realm of top management decision makers. If make or buy decisions are made at the purchasing level, strategy for the corporation may be made by default and lead the firm into paths which top management would not othewise have chosen. It is unlikely that this pattern is explicitly chosen or recognized by top level executives, who have primary responsibility for setting direction for the organization. We propose, then, that make or buy decisions should be recognized as strategic in orientation, and placed back on the agenda of top management where the strategic aspects may be periodically evaluated before the optimizing process of the purchasing department begins or enters a new cycle.

Perspective

sided,

Purchasing,

77,

51-53,

3

decisions shift like quicksand, 19 September (1972). pays off, Purchasing,

pp.

(1 S) Leif Melin, Strategic purchasing actions: a study of organizational learning. Paper presented at the seminar on Industrial Marketing-Theory and Practice, Yytaholm, Sweden, 21 November (1976). Leif Melin, Relations development-a strategic answer to the changing industrial purchasing environment. Research Report No. 24, Department of Management and Economics, S-581 83 Linkoping, Sweden. (20)

Electronic News, 18. 28-29,

3 September

(19?3).