High tech manufacturers have always faced the build-versus-buy dilemma in procuring “tools”, defined as capital equipment systems for the purpose of design, development, or production (e.g. test equipment). This is a question well worth revisiting, as the wrong decision can undermine the bottom line in a subtle and insidious way -- especially in these hard economic times.
Conventional wisdom mandates that a modern company build only such tools that enhance ROI and build up their competitive advantage; all others should be outsourced. So why is it that (otherwise) level-headed companies ignore this principle? All too often, they carve out valuable engineering resources and assume unnecessary market risks, when a perfectly good and highly economical solution -- in terms of quality, features, and cost -- is ready and available for purchase.
To properly evaluate the buy-versus-build alternatives, all the factors need to be weighed:
- First costs (bill of materials and assembly)
- On-going maintenance
- Upgrades and scaling
- Time to market advantage
- Opportunity costs of capital and resources
The bad news is that the only real factor that tips the decision is the first one: hard costs -- everything else is “squishy” and too easily manipulated to get the desired result. Hence, proper costing methodology is critical to decision-making. The rest of this article will look at some of the most common errors and shortcomings that are committed in the costing process.
Error 1: Creative Cost Allocation
Companies tend to allocate the costs of producing tools into functional departments which include engineering, equipment manufacturing, and operations (i.e., the eventual user). Depending on the specific practices of the accounting department, such costs are expensed, capitalized or transferred to other departments.
The costs begin when engineering is assigned the task of developing the equipment. During the early stages, engineering will incur the following costs, not all of which are normally identified and quantified:
- Firmware engineering labor
- Software engineering labor
- Hardware engineering labor
- Sustaining engineering labor
- Document control
- Prototype parts and supplies
- Floor space
- All related payroll burden, and company support costs
Companies are induced to expense these costs because of the following:
- Generally accepted accounting principles allow for expensing of research and development
- Since these costs are not attributed to capital equipment, the firm’s property tax bill will not be increased
- “Hiding” such costs in the engineering expense budget facilitates their claim for research and development credits.
Nevertheless, the time expended by the engineering staff for the development and ongoing support of the equipment needs to be recognized as a major cost of building the equipment in-house.
Other “costs” due to reallocating engineering labor are more difficult to quantify but no less important. Every engineer that is sequestered to build tools is lost to the strategic imperative of building competitive differentiation.
Error 2: Accounting Guesswork
Transfer of the engineering costs to the next department involves accounting guesswork -- the inaccuracies of which are passed on to the next department, including the group where the tool will be built and assembled. The following costs are then incurred, not all of which are normally identified and quantified:
- Assembly labor
- Quality inspection labor
- Purchasing and stores labor
- Floor space
- Capital equipment
- All related payroll burden, and company support costs
Error 3: Overhead
The most egregious omissions normally occur with regard to the “burden” costs of materials (i.e., freight, sales tax, purchasing and stores functions, scrap, board rework, samples, replacement parts, etc.). It’s not uncommon to ignore or underestimate some or all of these costs. Even when these costs are properly identified, they are expensed. Hence they are eliminated from a valid cost/benefit comparison against the alternative, which, of course, bears these corresponding costs in its price.
Standard rates are utilized in allocating assembly labor. However, accounting must provide a standard labor rate and standard production hours to allow such allocations. In determining the standard labor rate, costs such as training, hiring and other personnel costs are not considered.
Although overhead typically costs two to three times the labor costs, assembly overhead (floor space, management, indirect labor capital equipment depreciation, etc.) is not always allocated to the total cost of the equipment.
Error 4: Cost Allocation to End Product
Manufacturing (the end user in this instance), enjoys the apparent benefits of these accounting oversights and anomalies. Because a lower price has been transferred to them, less depreciation is charged to the department and they have -- on paper -- reduced the manufacturing cost per manufactured product (e.g. disk drives). So it seems that everyone is a winner.
However, once manufacturing inherits the tools, it incurs the costs for replacement parts and technical support for this in-house equipment -- costs that are usually covered by the warranty from external vendors. These are real costs to the company and negatively impact the bottom line -- though this is not easily identifiable after the fact. And everyone is genuinely befuddled when the actual net margins don’t measure up to expectations.
Even the accounting and finance departments cannot escape the real incremental costs of building in-house. From the initial engineering efforts through final production of the finished product (typically 12 to 18 months), the costs must be financed. The finance costs for in-house production begin on day one, however finance costs for purchasing a unit from an external vendor don’t begin until 30 days after the unit is delivered. The difference is expensed and never considered in the decision-making model. It is yet another unidentified cost that lurks in the bottom line.
Although the build-versus-buy debate should consider many and varied elements in the cost/benefit analysis, the estimate of first costs has a disproportionate influence on the resulting decision. It behooves a manufacturer to apply the same diligence and accurate accounting methods to this process as is given to the firm’s main product line. The temptation to marginalize the costs of the in-house alternative can be compellingly seductive when, as is the case with many companies, the very group which stands to be impacted by a “buy” decision is given the responsibility to make the case between building in-house or buying externally!
This often leads to the wrong decision, and ultimately disadvantages the competitive position of the company.
During his 25 years in the technology and telecommunications industry, Tony Lavia has served in executive positions with public companies and has been CEO of several startups, in the U.S., Canada, Europe, and Asia. At present he is President and CEO of Flexstar Technology, a private company that leads in the development of QA test systems for the storage industry. For more information, visit www.flexstar.com