Make or Buy Decision In Supply Chain Management

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Make or buy decision in supply chain management. or, Buy or Lease and Subcontracting.

Make or buy decision in supply chain management
Make or buy decision in supply chain management

Make or buy decision in supply chain management.

A Manufacturing company cannot produce by itself all the components required by it sometimes it may have capacity to produce. Still a make or buy decision in supply chain management has to be made weather it is economical to produce in house or buy it from outside.

Factors in favour of making components in house

  1. It is cheaper in cost as compared to buying from outside
  2. Excess plant capacity available which can absorb overheads
  3. Extensive investments beyond capacity of supplier required to create facilities to produce specialized items.
  4. The item has relatively large and consistent demand.
  5. Supplier not interested due to small quantity required.
  6. Company has necessary equipment’s, expertise which can be utilized profitably to produce an item similarly or closely allied to its main products /components.
  7. Very big items which are difficult to transport.
  8. Company intends to maintain secrecy of product design and manufacturing prices
  9. Existence of only one non-dependable supplier in terms of quality, delivery schedule, financial stability etc.
  10. Company may be interested in forward or backward integration
  11. To utilize the existing manpower effectively in recession Times
  12. To reduce ultimate cost of product by reducing expenses in excise duties, sales tax, octroi, etc.

Factors in favour of buying a component from outside sources

Cheaper in cost as compared to in house production.

  1. Necessary space equipment’s time and manpower skills not available in house.
  2. Company does not want to make new investments which can be used beneficially elsewhere.
  3. Existing facilities can be used more profitable by produce other components.
  4. Legal barriers prevent company to produce in house. For example environment problems, patents etc.
  5. Inconsistent demand.
  6. Supplier specializes in that component and can give better quality.
  7. Availability of good number of suppliers offering better selection choice.
  8. Status of Industrial Relations in company.

Make or buy decision in supply chain management. Should be evaluated continuously as Technology as well as internal and external environment of company is changing continuously. For this purpose and analysis of the present and future market and economic Trends, supplier evaluation, new development in the raw materials and processes etc. is necessary.

Engineering units generally preferred to buy them to make due to following factors

Components manufacturer being specialist for that product can produce at much lower price than producing in house.

  1. Such specialist manufacturer keeps track of new technologies and can make necessary investments to ensure good Returns.
  2. Parent company sets up ancillary units, which are joint venture of partnership companies e.g. Telco have set up ancillary units like Tata toyo Limited, JBM tools PVT Ltd. which produce specialized components for a Telco.
  3. Due to less inventory new concepts like just in time, total quality management (TQM) etc.  Can be taken up.

Buy or lease decision.


The international accounting standard- 17 defines lease as “An agreement whereby the lessor conveys to the lessee for rent, the right to use an asset for an agreed period of time”. This includes a contract for the hire of an asset, which provides for giving the hirer an option to acquire title to the Asset upon the fulfillment of certain agreed conditions.

The point to be noted here is that through lessee pays ‘lease rental’  to lessor over a period of time at and prefix rate at fixed interval, ownership of asset remains with lessor or Lessee gets only right to use that asset.

 Types of leases.

  1. Financial lease.

This lease transfers majority of the risks and rewards pertaining to the ownership of an asset, though its title may or may not be subsequently transferred. In this lease, the rental payable during the period recovers the capital cost of the asset and contributes to the profits of lessor. This enables lassor write off the asset and dispose it of the way he likes.

In this lease, the lessor retains the ownership of the assets during the lease period, through a purchase option or reduced rentals may be provided after the lease period. During the lease period/ primary period lassor receives the cost of the Asset and his profit.

During secondary period the lease may be continued on payment of substantially lower rental. Through the lessor is the legal owner, the risks and rewards incidental to ownership pass on to the lessee. Hence lessee is supposed to pay for the insurance, maintenance of the Asset, etc.

This Lease is non-cancellable by both sides except in the event of default according to provisions of the law during the primary period of lease. The lease has the exclusive right to retain position and to use the assets object to complying with the terms of the lease agreement.

  1. Operating leases

In this type of lease the owner/ lesser of an asset agreement to lease the asset for a specified period for an agreement sum to be paid as rentals and who Retains all risks and rewards incidental to ownership.

In this lease, the lessor maintenance the assets leased in good condition and retains ownership of an asset during and after the lease period. The Lessee has the exclusive right to possess and use the assets. The lease period is generally shorter up to 1 year. The lease rentals over one single lease period generally do not cover the cost of the Asset.

Advantages of leasing

  1. Burden and cost of likely obsolescence shifted to the lessor.
  2. Leasing is better option on short term basis than outright purchase of an asset in rapidly changing technological environment.
  3. Enables organizations with uncertain incomes the use of an asset.
  4. It is more flexible than ownership.
  5. Allows companies to expand gradually as they cannot invest in assets.
  6. Leasing offers sometimes cost savings over direct borrowings.
  7. Allows companies to expand gradually as they cannot invest in assets.
  8. Lease financing is better option when an equivalent amount of Debt. Finance is not available.
  9. Enable to avail certain tax benefit as lease payment is tax deductible.
  10. Leasing reduces the risk of obsolescence of assets.
  11. More preferred by institutional in inventor who want to earn higher rate of return on their assets.
  12. Preferred by companies who operate within Limited working capital.
  13. Some Leasing companies provide asset along with labor so lessee need not face Union and Labor problems.

Disadvantages of leasing.

  1. Cost of living high on long term basis.
  2. In case of long term and non-cancellable lease, lessee is required to face the danger of obsolescence
  3. Lease rentals being fixed, lessee cannot enjoy the benefit of decreasing interest rates.
  4. When the lessee enters into leasing agreement, it is difficult to understand the implications of financial resources.
  5. Lessee cannot take advantage of and potential capital gain in case real estate value increases during lease period.
  6. The interest cost of lease financing is generally higher than that of debt financing.
  7. Ownership of asset remains with laser hence we cannot benefit from increase in value of property due to inflation and demand.

Contents of the lease agreement.
The lease agreement generally contains information of following.

  1. The least transaction.
  2. Title, identification and ownership of an asset.
  3. Cost of maintenance and use.
  4. Liabilities of the lessee.
  5. Liabilities of the lessor.
  6. Default of the lessees.
  7. Remedies in event of default.


Subcontracting involves procuring parts and components required to produce main product from outside sources.

For example, Bajaj Auto Limited. Manufacturer’s scooter and motorcycles. Bajaj Auto Limited procure large number of components and parts required to manufacture scooter on motorcycle from outside resources. The main reason for subcontracting is to reduce costs. The small manufacturer’s overhead being low he can supply the same components at much lower cost than producing in house.

It is a common practice in large automobile and engineering companies to subcontract large number of components to small scale manufacturers who specialize in particular line / activities casting, forgings, auto Electricals, rubber parts, transmission products like gears, pulleys etc.

subcontracting in was following activities

  1. Vendor development

Various actions related to this activity can be given below

  1. Identification of vendors.
  2. Guidance to vendors to procure the required components of desired quality and price
  3. Optimization of number of vendors
  4. Evaluating of  vendors
  5. addition and deletion of vendors

Before selecting the vendor companies first evaluate their strength, capabilities by Reference, visit to their factory. they inspect the facilities available for production, quality control etc. now a days  a large companies are trying to reduce the number of vendors and new suppliers are not encouraged unless they have something special than others. New suppliers are asked to route their products through selected few vendors. The intention behind this is to reduce administrative time and cost spent on dealing with large number of suppliers. Secondly companies want to develop strong business relationship with selected few vendors.

  1. Purchase formalities.
    This includes routine formalities like sending enquiries, obtaining quotations, placing orders, follow-up and receiving and inspection.
  2. SystemsStandardizing the designs of the components needed frequently enables to develop specialized skill of vendors. It is also expected that purchasing procedure should also be standardized.Various areas in which purchaser in large company should provide attention in subcontracting are as follows.
  3. Establishing delivery schedule.This is necessary to receive uninterrupted flow of components from vendors to the company on desired time. Company is expected give sufficient Lead time as well as necessary drawings and designs to vendor to ensure getting deliveries as fixed delivery schedule.
  4. Prompt payment to vendor on deliveries.
  5. Ensuring quality standardsFor obtaining desired quality from supplier it is necessary that company provides guidance, Technology know how and test facilities to vendor when not available with him. Sometimes companies may provide raw material and to the necessary to produce the desired component. In such case company pays the full cost of the tools required by vendor for producing the components required by the company. The vendor is responsible for maintaining the tools in good condition. It is expected that the vendors should send back the tools along with the components produce to the company on completion of order.Sometimes the cost of tools is borne by vendor and the company on mutually agreed terms.
  6. Record Keeping. Company is expected to keep records of all new raw materials sent to vendor and received back from him. Similarly annual or 6 monthly stock level maintained by vendor for all goods supplied by company should be recorded. This is necessary from audit point of view.

This is all about to make or buy decision in supply chain management


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