Buy vs. Build: Starting With A Clean Sheet Of Paper

Abstract

Abstract needed here…

Article
In 1857, Buena Vista, the first modern, vertically integrated winery in the Sonoma Valley of California was opened by an eccentric character named Count Agoston Harazthy. Prior to that time, northern California wines were bottled by city merchants who simply repackaged juice purchased from local farmers, who crushed and roughly fermented whatever grapes they could grow. Needless to say, this process produced an unpredictable, poor-quality product. So even though Buena Vista’s wine was more expensive, its superior quality was quickly recognized and it became a widely preferred brand.

Unfortunately, the Count did not enjoy his success for very long as his financial backers accused him of “extravagance” in his handling of Buena Vista and ousted him from the company. Shortly thereafter he emigrated to Nicaragua, fell into a river, and was eaten by an alligator.

And the moral of the story is?

Perhaps manufacturing a high quality product on a consistent basis—especially when others are not—is a good idea even if prevailing opinion brands it an extravagance. Hopefully being eaten by an alligator was an anomaly.

So how does this situation apply to today’s electronics industry?

As in the days of Count Harazthy, the number of manufacturing strategies from which to choose has not changed; there are still only two: buy or build. Likewise the fundamental objective of a for-profit business has not changed, that being providing the best possible long-term rate of return for shareholders and stakeholders. What has changed is the number of potential supply solutions available for the buy option, including EMS, ODM, JDM, OBM, and others, be they regional, domestic, continental, or off-shore.

Given all these supply options, it seems reasonable to assume it would be cheaper for an OEM to buy versus build their own product.

Yes, in a large percentage of cases it is cheaper for an OEM to outsource the build of their product to an external manufacturer. However, unless they calculate their internal cost of manufacturing, how do they not know for certain it is cheaper to outsource?

We made the buy versus build calculation a long time ago, and since have eliminated the production resources necessary to perform the work internally.

Then let us review the elements of the buy versus build calculation and see how perishable the variables might be. As in any return-on-investment analysis—be it a net-present value, rate of return, or a simple payback calculation—there are only three major items to be considered:

  1. Total Cost of Ownership (TCO)
  2. Strategic Advantage
  3. Potential Risk

Looking at each in order—and understanding that every business is unique and therefore needs to generate its own list of specific concerns—we can outline the sub-elements of the three major items and estimate how circumstances have shifted over recent time.

1. In the simplest of terms, TCO includes:

Total Cost of OwnershipStart-up Costs (Non-Recurring)Recurring Costs (Direct and Indirect)
Buy OptionHave increased sharply as production has moved to progressively remote geographies (e.g., USA/Canada to Mexico, Mexico to China, and China to India).Have been increasing on a Net basis since mid-2004 as demand approaches capacity in low-cost geographies and landed costs and support cost (due to fuel surcharges) have risen dramatically.
Build OptionHave been decreasing as the costs of domestic resources (facilities, equipment, and trained people) are in considerable surplus.Lower than historical norms as companies have reduced overheads and converted many of their fixed costs to a variable basis.

ASSESSMENT: TCOs completed over one year ago, or prior to the implementation of a progressively regionally remote supply solution, are probably out of date and should be revisited.

2. Strategic advantage includes both the timely penetration of underserved market opportunities (i.e., expanding the total available market or TAM) and competing for a larger market share of the current TAM. Either strategy, if successfully executed, provides the opportunity for margin enrichment.

Strategic AdvantageCompetitiveness (Pricing/Margins)Velocity (Speed to Market)Differentiation (Innovation)
Buy OptionWhile initially very significant, currently this trend is reversing as reductions in the underlying costs have driven broad-based price reductions across most market segments.Increased with integration of ODM option, but have slipped due to long supply lines and reduced flexibility levels.Decreased significantly with use of ODMs, which has resulted in many market sectors becoming commoditized.
Build OptionStable to slightly increasing as social costs continue to escalate in most Western geographies.Increasing dramatically as domestic supply continues to exceed demand.Stable except in the area of customer service, which has been expanding as a differentiator.

ASSESSMENT: As a result of commoditization, product pricing has lost much of its applicability as a strategic advantage while market velocity and innovative differentiation (in either service or technology) have become more important. Therefore, any strategic assessment originally weighted heavily on cost of goods sold (COGS) does not reflect current market objectives and should be re-factored.


3. The final major variable in the buy-versus-build calculation is potential risk, which is typically applied as a negative to both supply options.

(TCO + Strategic Advantage) – Potential Risk = Relative Value of Option


Historically, potential risk—especially in the area of supply continuity—was considered to be much higher with the buy versus the build option. But as companies switched from vertical to virtual business models and began to shut down or divest their internal manufacturing operations, this assessment reversed outcome.

Potential RiskAlignmentFlexibilityPortabilityContinuity
Buy OptionService offerings by external manufacturing companies continue to expand and therefore are progressively compliant to requirements. However, concerns over transparency and protection of IP remain unmitigated.Manufacturing in regionally remote geographies lengthens supply lines and response time and reduces flexibility and predictability, especially when non-domestic materials make up a large portion of the bill of materials.As services shift from assembly, to integration, to design, to fulfillment, migrating risk between supply sources becomes progressively more complex and expensive.Convergence of the EMS/ ODM models, consolidation via globalization, and the resulting scale of the top-tier service companies, virtually guarantees additional compression of the supply solution.
Build OptionInternal resources can be more accurately aligned with both current and future requirements. But the financial risk becomes a wholly owned responsibility of the OEM.Can be more responsive to both upside and downside needs as internal operations are more closely entwined in the underlying business process, as long as there is a commitment to support required inventory levels.Given the supply/demand imbalance in the commercial markets, inside resources can not reasonably be considered to be portable at this time.As OEMs usually have greater influence with the supply chain than do external service providers, net of disaster contingencies, the on-site option continues to be less risky.

ASSESSMENT: Unless the OEM is a top-tier consumer (spending more than US$1 Billion per year on external manufacturing—which assures them special consideration and treatment by most service providers) the potential risks of manufacturing externally now tend to exceed those of manufacturing internally. This is especially true in the early and late life-cycle stages of most products, when there are IP related issues, or when a high percentage/or value of non-domestically procured materials (to the manufacturing site) are utilized in the product.



As a closing comment on risk, keep in mind that business is an inherently risky proposition and today’s highly leveraged, maximum-velocity, minimum-inventory, lowest-possible-cost business model tends to make the situation even worse.

So manage risk, instead of letting it manage you. A few points to consider:

  1. Think out of the box. While it is probably impossible to list every potential risk, it is reasonably possible to categorize their consequences to your business, which will help focus your planning.
  2. Never allow yourself or your organization to talk itself into believing anything that runs counter to common sense, human nature, or the fundamental tenets of business.
  3. Remain proactive and continually evaluate potential tools, information sources, and alternative practices. Given that change is a constant, it would be reasonable to assume the actions, plans, and courses we set for our business today will be obsolete and ineffective tomorrow.

So what does it all mean? What’s the bottom-line: Buy or Build?

There is no single correct answer. Buy versus build is a decision executives need to make each time they encounter a junction on the highway of commerce. Sometimes, and on some products, the answer will be build. At others times it will be buy. The only way to choose the optimal path is to do the analysis—just remember to start with a clean sheet of paper.

One more thing, should you find yourself in Nicaragua try not to fall into a river and be eaten by an alligator.


TFI Senior Consultant Charlie Barnhart is a frequent contributor to TFI’s Quarterly Forum for Electronics Manufacturing Outsourcing and Supply Chain. He can be reached at cbarnhart@techforecasters.com

© 2005 Technology Forecasters Inc.,
2000 Santa Clara Avenue, Alameda, CA 94501 USA. Phone 1-623-293-6985
http://www.techforecasters.com/

Scroll to Top