GB570 Unit 4 Make or Buy Analysis Example

Fifty-Eight Cents a Kilogram on Paper: A Unit 4 Make or Buy Analysis of Bulk Olive Oil Consolidation

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Purdue University Global

GB570: Managing the Value Chain

Unit 4 Make or Buy Analysis

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[Date]

The company, its suppliers and every figure are composite and illustrative; the frameworks and sources cited are real.

The Decision

Alder Quay buys about 870 tonnes of bulk extra virgin olive oil a year from one Lisbon exporter at $6.77 a kilogram, roughly $5.89 million. The exporter buys from eleven mills, stores the oil in nitrogen-blanketed tanks, filters it, has it tested and ships it in monthly loads. The question is whether Alder Quay should do that work itself by leasing a site near Évora, building a 1,500-tonne tank farm with a small laboratory, and buying oil directly from mills at about $5.57 a kilogram.

The two cases are built separately below, at equal depth, before any verdict.

The Case for Making

The saving per kilogram. Buying at the mill gate removes the exporter's capture of about $1.20 a kilogram. Running the facility would cost about $0.62 a kilogram in storage labor, nitrogen, filtration, laboratory tests, local staff and site lease, so the variable saving is about $0.58 a kilogram, or roughly $505,000 a year at current volume.

Control over lot selection. Alder Quay's tasting panel now chooses among lots the exporter offers. Owning the tanks would let the panel taste at the mills during harvest and reserve the best early-harvest lots before other buyers see them.

A stronger origin claim. With its own segregated tanks, Alder Quay could document every lot from mill to container without relying on the exporter's records, which matters for the single-origin claim on its label.

Learning. Venkatesan (1992) warns that firms which outsource a stage close to their product's quality gradually lose the ability to judge that stage. Running the tanks would keep Alder Quay's staff close to the oil in the months when its quality is decided.

The Case for Buying

Idle capacity. A tank farm must hold a whole harvest, because mills sell most of their oil between November and February. The facility is sized at 1,500 tonnes to allow for growth and for a large harvest year, so at 870 tonnes it would run at 58 percent of capacity. Depreciation on $2.6 million over fifteen years is about $173,000 a year whether the tanks are full or not.

A year of stock on the balance sheet. The exporter now finances the oil between harvest and shipment. Buying at the mill gate means Alder Quay pays for most of a year's oil in the winter and draws it down over twelve months. Average inventory would be about $2.4 million, and at a 9 percent cost of capital, carrying it costs about $218,000 a year, or about $0.25 a kilogram.

Blending across eleven mills. One mill can have a poor year from hail, drought or a fly infestation. The exporter's spread of mills lets it substitute lots without the buyer noticing. Alder Quay, buying from perhaps four mills, would carry that risk itself.

Testing credibility. The exporter's samples go to a sensory panel recognized by the International Olive Council, and its chemistry results come from an accredited laboratory. Alder Quay's own small laboratory could run routine tests but would still need outside panels for any result a grocer or regulator might challenge.

Currency. The exporter invoices in dollars under the annual contract. Portuguese mills invoice in euros, so making would add currency exposure that Alder Quay does not now carry.

The Numbers Side by Side

Buying costs $6.77 a kilogram, about $5.89 million a year. Making costs $5.57 for oil, $0.62 for operations, about $0.25 for carrying the harvest stock and about $0.20 for depreciation, a total of about $6.64 a kilogram. The full saving is therefore about $0.13 a kilogram, roughly $113,000 a year, not the $505,000 that the variable comparison suggests. A cash payback, ignoring depreciation, runs about nine years on a $2.6 million investment.

On a variable comparison the tanks save half a million dollars a year; once the harvest stock and idle steel are counted, they save about one-fifth of that.

Sensitivity

Two changes test the result. If volume fell by a quarter, to about 650 tonnes, the full saving would drop to about $42,000, because depreciation stays fixed while savings fall. If the exporter, faced with losing the account, cut its price by 4 percent to $6.50 a kilogram, making would lose about $122,000 a year. The exporter has a strong reason to make that offer, since Alder Quay is one of its larger customers. In the other direction, volume growth of about 50 percent, to roughly 1,300 tonnes, would lift the saving to about $255,000 and bring the facility close to 87 percent use.

The make case therefore wins only if Alder Quay expects substantial growth and the exporter does not respond on price. Neither condition can be counted on.

What the Firm Cannot Give Away

The make case rests on two real concerns: that Alder Quay is losing touch with the oil at the stage where its quality is decided, and that its single-origin claim depends on another firm's records. Quinn and Hilmer (1994) argue that a firm should keep in-house the activities where it can achieve definable preeminence and outsource the rest, and both concerns point to the same capability. What Alder Quay cannot give away is not the tanks. It is the specification: which mills, which harvest weeks, which chemistry thresholds and which sensory profile qualify a lot for its bottle. Storage, filtration and shipping can be bought from anyone with steel tanks. The judgment about which oil goes into the bottle is what customers pay for. Williamson (1985) would add that the tanks carry little asset specificity, since any exporter's steel can hold any mill's oil, and that is the condition under which buying from a market usually beats owning the stage.

Verdict and Trigger

The analysis recommends that Alder Quay keep buying from its exporter, and that it rewrite the supply contract around its own specification. The new contract would let the tasting panel reserve lots at named mills during harvest, require tank-by-tank segregation records for every lot shipped under the single-origin label, set minimum chemistry thresholds tighter than the extra virgin standard, and give Alder Quay the right to send a staff member to the exporter's facility during the harvest months. A modest annual fee would be reasonable in return.

The decision should be reopened if annual volume passes about 1,300 tonnes, or if the exporter refuses the segregation clause. At that volume the facility saves more than $250,000 a year on full cost, and without segregation the origin claim on the label cannot be supported.

References

Quinn, J. B., & Hilmer, F. G. (1994). Strategic outsourcing. Sloan Management Review, 35(4), 43-55.

Venkatesan, R. (1992). Strategic sourcing: To make or not to make. Harvard Business Review, 70(6), 98-107.

Williamson, O. E. (1985). The economic institutions of capitalism: Firms, markets, relational contracting. Free Press.