204 Corporate Finance
HLL’S PERSPECTIVE: MAKE OR BUY?
The make or buy analysis essentially involves comparing the cost of manufacturing (making) in-house and
the cost of buying. To illustrate, assume that a company requires 10,000 units of a product for the next
20 years, and the demand is expected to be constant. A supplier is currently making it for Rs 20.^1 A brief
calculation suggests that it can be made in-house for Rs 15. The calculation:
(in Rs)Cost of making Per unit Total
Labor and material 5 50,000
Depreciation 10 100,000
Total 15 150,000
Cost of buying 20 200,000
Saving 5 50,000
The depreciation expense results from the machine that is purchased to produce the part for Rs 20 lac. The
machine is expected to have a life of 20 years and the interest cost of the borrowed funds is 10 percent. The
analysis is incomplete because it ignores time value of money. Assume that the labor material expense will
be incurred at the end of the year and the payment for the machine is made at the beginning. The present
value (@10 percent) of making 10,000 units for 20 years is:
Outlay (in Rs) PV factor PV (in Rs)Labor & material 5,000 8.5136 425,680
Equipment cost 2,000,000 1.00 2,000,000
Cost of making 2425680
Cost of buying 200,000 8.5136 1,702,720
This analysis suggests that it is cheaper to buy.
How should HLL decide whether to produce in-house or buy from DIL? That depends on several factors:- Price quoted by DIL.
- Cost of setting up a plant.
- Impact of increased complexity on the organization (HLL) (and hence on profits).
- Cost of materials. It is possible for HLL or DIL to have comparative advantage in purchasing raw materials.
If HLL indeed has economies of scale in purchasing it makes sense to get into a processing agreement with
DIL rather than allow DIL to purchase on its own and bear the inefficiency in the sense that DIL would
pass on the benefit to HLL. - Labor expenses and other variable expenses per unit of output at HLL.
- Savings arising out of reduction in logistics.
(^1) This numerical is adapted from Bierman, Harold and Seymour Smidt (1993). The Capital Budgeting Decision, Macmillan
Publishing Company, New York.