Stories From the Field # 5 - April, 2004
Make-Buy Decision Using Value Stream Costing
by Brian H. Maskell, President BMA Inc.
An electromechanical products manufacturer was faced with the classic problem; should they manufacture their new product family in the USA or out-source them to a "low cost country". The low cost country in this example is in Eastern Europe. Here's how they would traditionally make this decision.
The Product Manager for this new family of products presented this information and showed clearly that the most advantageous approach was to purchase the products from the low-cost country. "If we make this in-house we will be giving money away on every unit." The company's executive team readily concurred with this decision.
The Value Stream Manager also agreed that this was the right thing to do, because he could not argue with the financial analysis. But his gut feel was that his value stream team should be able to make these products cheaper, faster, better, and offer the customers very short lead times and a lot more flexibility. The company had been working at introducing lean manufacturing methods for a couple of years. They were well aware of their slow progress; but the measurement systems show that this value stream was at least 25% more productive, inventory levels had been cut in half, the production lead time had gone from 25 or 35 days down to less than one week. How come they could be beaten by one of those ex-Soviet places !!
The Value Stream Manager wanted to pursue his intuition about these new products, and he enlisted the help of the Plant Controller to look at the "true" costs of the value stream. At first they went down a number of blind alleys by attempting to find different ways to allocate the costs to the products. But every time they tried this, all they got was arguments from the Product Manager - and endless meetings and more bad blood between marketing and operations.
The breakthrough came when they realized that it was pointless looking at these new products in isolation. They needed to look at the entire value stream. Adding a substantial new product family to an existing value stream changes the cost structure of the value stream. They needed to understand this. The first step was to work out the financial benefit of this new product family if it was out-sourced to Eastern Europe. Here's what this looks like:
Clearly this new product family - if it met its sales predictions - would greatly improve the Value Stream profitability. There would be additional costs for warehousing the products because the freight costs from Eastern Europe meant that it was economical to place large orders. But the VS Manager had a mandate to bring the Return-on-Sales (ROS) of his value stream up to 20%. This new product family would get them moving swiftly in the right direction.
Next the VS Manager and the Plant Controller worked on the "true cost" of making the product family in-house instead of out-sourcing them to the low-cost country. Here's how the numbers worked:
The raw material costs will increase by $74 per unit. There will be a need for four additional production operators. The labor costs in the routing would suggest that 9 people are needed to manufacture this product, but the lean manufacturing improvements over the last couple of years have freed up a good deal of capacity within the plant, plus the level of quality is much higher and a lot less time is required for scrap, rework, and the general mayhem traditionally caused by poor quality. The 5 day production lead time has eliminated a lot of wasteful work expediting, splitting batches, and pushing product out of the door at the last minute.
Admittedly, keeping the additional people down to only four, will require a good deal of additional work on process-flow and a lot more waste elimination throughout the value stream. But most of these improvements are already in the schedule; they have been documented on the Future State Value Stream map, and the team is confident they can achieve them.
It soon became clear that the best course was to make these new products in-house. The standard cost approach had been thoroughly misleading. Far from it being profitable to out-source this product family, the value stream would increase it's profitability significantly by making the product in-house and leveraging the company’s newly acquired lean manufacturing skills.
Another twist on this story is that the Product Manager soon came into agreement. Initially she accused the Plant Controller of creative accounting but when she was shown that the figures presented were real numbers and not fictitious allocations and accounting witchcraft, she saw that this was the best decision for the company and for her product portfolio.
Here are the final figures:
Finally it is worth noting also that these figures contain only "hard numbers". No additional expenses have been added for the increased costs of supporting production from distant suppliers. Many companies find their travel costs increasing owing to engineers, managers, quality people, and planners having to make frequent trips to solve supply problems. Other expenses include additional air-freight when product is required inside the suppliers (long) lead time. There is also a cost associated with the risks of sourcing from some of these low cost suppliers. Many companies claim their designs are "pirated" and find similar products being manufactured for their competitors. Some realize - to their chagrin - that they have worked hard training their future competitor. None of these "soft" costs were taken into account in this make-buy decision.
(For more discussion on the risks of out-sourcing to low-cost countries, see Jim Womack’s article:
"Move Your Operations to China? Do some lean math first."