5.6 Production planning

Learning objectives

• Explain the stages of local and global supply chains and the roles of logistics and supply chain management.

• Evaluate just-in-time (JIT) and just-in-case (JIC) approaches to managing stock.

• Construct and interpret a stock control chart showing lead time, buffer stock, reorder level and reorder quantity.

• Calculate the reorder level, reorder quantity and maximum stock level from data.

• Calculate and interpret the capacity utilisation rate and the defect rate.

• Calculate and interpret labour productivity, capital productivity and the productivity rate.

• Explain operating leverage and calculate the degree of operating leverage.

• Calculate the cost to buy and the cost to make, and recommend whether a business should make or buy a product.

Introduction

Production planning is the part of operations management that makes sure the right materials, people and machines are available in the right quantities at the right time, so that a business can meet demand at the lowest possible cost. It covers the supply chain that brings materials in and takes products out, the management of stock, the use of capacity, the measurement of efficiency and quality, and the decision whether to make a component or buy it from another business.

Poor planning is expensive in both directions. A business that holds too little stock or too little capacity loses sales and disappoints customers; one that holds too much ties up cash and pays for space, staff and machines it does not use. In 2021 a shortage of semiconductors stopped car factories around the world, and the car makers that had planned for such a disruption lost far less output than those that had not.

The supply chain

Almost no business makes a product entirely by itself. A bakery buys flour, which a mill made from wheat grown by a farmer; it sells bread through its own shop and through supermarkets. Each of these businesses is a link in a supply chain, and the bakery depends on every link working.

A supply chain has two kinds of flow. Goods and services move forward, from raw materials towards the consumer. Orders, information and payments move backwards, from the consumer towards the producers of raw materials. A supply chain works well only when both flows are fast and accurate: a retailer that does not tell its suppliers about a rise in demand will soon run out of stock, however efficient the factories are.

The stages of a supply chain

The stages differ between industries, but most supply chains for physical goods include the following:

1. Raw material producers: farms, mines, forests and oil and gas producers extract or grow the basic inputs.

2. Component suppliers: businesses that turn raw materials into parts, such as steel sheet, glass, fabric or electronic chips. Large manufacturers have several tiers of suppliers: tier 1 suppliers deliver directly to the manufacturer, tier 2 suppliers deliver to tier 1, and so on.

3. The manufacturer: the business that assembles or processes the parts into the finished product.

4. Distributors and wholesalers: businesses that store finished goods in bulk and break them into smaller quantities for retailers. A wholesaler links many producers with many retailers.

5. Retailers: shops and online sellers that sell to the final consumer. A retailer often holds stock close to customers so that it can sell immediately.

6. Consumers: the people or organisations that use the product. Their purchases send the signal that sets the whole chain moving again.

The diagram shows a manufacturer at the centre of its supply chain. Everything to its left arrives as inputs, and everything to its right takes its products to market. A service business has a supply chain too: a hotel depends on suppliers of food, linen, cleaning materials, energy and booking platforms, and its product is delivered directly to the guest.

Logistics

Moving goods along the chain is a large activity in itself. Logistics covers transport, warehousing, handling and the information systems that track goods. Logistics into the business (raw materials and components) is called inbound logistics; logistics out of the business to customers is outbound logistics.

Many businesses buy logistics from specialists, known as third-party logistics providers, which run warehouses and transport fleets for many clients and can spread their costs over a large volume of goods. Good logistics lowers costs, shortens delivery times and reduces damage and loss. It also matters for sustainability, because transport is a large source of emissions: choosing rail or sea over air freight, filling vehicles fully and planning routes to avoid empty return journeys cut both costs and emissions.

Supply chain management

Supply chain management (SCM) goes beyond moving goods. It is the coordination of all the businesses in the chain so that the final product reaches consumers at the right time, quality and cost. A business with good supply chain management knows who its suppliers are (including the suppliers of its suppliers), shares information with them, and plans for what could go wrong.

The main activities of supply chain management are:

• Choosing and managing suppliers: selecting suppliers on price, quality, reliability, ethics and location, and building long-term relationships with the most important ones.

• Sharing information: sending sales data and forecasts along the chain so that suppliers can plan their own output. Shared data reduces the "bullwhip effect", in which small changes in consumer demand turn into much larger swings in orders further back in the chain, because each business adds its own safety margin.

• Managing stock: deciding how much stock to hold at each stage, and where (the JIT and JIC approaches).

• Managing risk: identifying links that could fail, such as a single supplier of a critical part, and planning alternatives.

• Monitoring standards: checking that suppliers meet quality, labour and environmental standards, which raises questions of ethics when suppliers are in countries with weaker regulation.

Local and global supply chains

A local supply chain sources its inputs and sells its output mainly within one region or country. A global supply chain links businesses in many countries: a smartphone may contain chips designed in the United States, made in Taiwan and assembled in China or India, before being sold worldwide. Most large manufacturers, and many multinational companies, depend on global supply chains.

Businesses build global supply chains because they can buy inputs where they are cheapest or best, reach larger markets and gain economies of scale. The costs are longer distances, longer and less predictable delivery times, exposure to exchange rates, tariffs and political risk, and less control over suppliers far away. Local supply chains are shorter, more flexible and easier to monitor, but inputs may cost more and the choice of suppliers is narrower.

The choice is rarely all or nothing. Many businesses keep a global supply chain for standard parts and use local suppliers for parts that are bulky, urgent or easily damaged. Decisions to move production abroad or bring it back home (offshoring and reshoring) change the shape of the supply chain, and they are taken partly for supply chain reasons such as lead times and risk.

Supply chain disruptions

A disruption is any event that stops or slows the flow of goods along the chain. Because each business depends on the links before it, a problem at one supplier can stop production at many businesses further along. The main causes are:

• Natural disasters: earthquakes, floods, storms and fires at factories or ports.

• Pandemics: closures of factories, shortages of workers and sudden changes in demand.

• Transport chokepoints: in March 2021 the container ship Ever Given ran aground in the Suez Canal and blocked it for six days; by 28 March at least 369 ships were queuing to pass.

• Conflict and political events: wars, sanctions, tariffs and attacks on shipping. In January 2024 attacks on ships in the Red Sea forced shipping lines to sail around Africa, and Volvo Cars paused production at its plant in Ghent, Belgium, for three days because gearboxes were delayed.

• Supplier failure: a supplier going out of business, a quality problem, a strike or a cyberattack.

• Sudden changes in demand: a rise in demand that suppliers cannot meet, or a fall that leaves them with unwanted stock.

Sources: Associated Press, 23 March 2021, and BBC News, "The cost of the Suez Canal blockage", 29 March 2021 (via Wikipedia, "2021 Suez Canal obstruction"); Reuters, "Volvo Cars pauses production in Belgium due to Red Sea situation", 12 January 2024.

Businesses reduce the risk of disruption by using more than one supplier for critical parts (dual sourcing), holding buffer stock, mapping their suppliers beyond tier 1, choosing suppliers in different regions, and preparing plans in advance through contingency planning. Each of these costs money in normal times, so the right level of protection depends on how likely a disruption is and how much it would cost.

Just-in-time and just-in-case

Every business has to decide how much stock to hold. Stock includes raw materials and components waiting to be used, work in progress on the production line, and finished goods waiting to be sold. There are two opposite approaches to this decision.

Just-in-time (JIT), a method of lean production, aims to hold as little stock as possible: materials arrive only when they are needed, in small and frequent deliveries, and production is pulled by actual orders. The opposite approach is just-in-case (JIC).

Under JIC a business orders in large quantities, holds a large buffer stock, and produces to a forecast rather than to orders. It accepts the cost of holding stock in exchange for security. Under JIT the business accepts the risk of running out in exchange for low stock-holding costs.

The two charts show the same rate of usage. The JIC business receives a large delivery every six weeks and never lets stock fall below 300 units. The JIT business receives about 50 units twice a week, so it holds a tenth of the stock or less, but it has almost nothing to fall back on if a delivery fails.

How the two approaches compare

The table shows a trade-off between efficiency and resilience. JIT minimises the cost of stock, so it is efficient when the supply chain works. JIC pays to hold stock, so it is resilient when the supply chain fails. The approaches also differ in their effect on working capital: cash held as stock is not available to pay suppliers or invest, so JIC weakens liquidity while JIT strengthens it.

Advantages and disadvantages of just-in-case

The advantages of JIT are the disadvantages of JIC, and the reverse. JIC has these main advantages:

• Protection against disruption: production and sales continue if a delivery is late, a supplier fails or transport is blocked.

• Ability to meet sudden demand: a retailer can sell immediately when demand rises, for example in hot weather or before a holiday, instead of losing sales to competitors.

• Bulk-buying discounts: large orders cost less per unit and need fewer deliveries.

• Protection against price rises: buying ahead locks in today's prices for materials whose prices are rising.

• Smooth production: a business with seasonal demand, such as a toy maker, can produce at a steady rate all year and build up stock before the peak season.

JIC also has disadvantages:

• High stock-holding costs: rent, warehouse staff, insurance, security, energy for refrigeration.

• Cash tied up in stock: working capital that could be used elsewhere, and a higher risk of liquidity problems.

• Risk of waste and obsolescence: food expires, fashion goes out of date and technology is replaced. Stock that cannot be sold must be written off or sold at a discount.

• Hidden inefficiency: large stocks can hide quality problems, unreliable suppliers or poor planning, which lean production aims to expose and remove.

• Environmental costs: unsold stock that is destroyed wastes the resources used to make it.

Evaluation: JIT or JIC?

Neither approach is better in all cases. The right choice depends on the balance between the cost of holding stock and the cost of running out of it, which in turn depends on several factors:

• Reliability and distance of suppliers: JIT needs suppliers that deliver on time, every time. Short, local supply chains suit JIT; long, global ones carry more risk and often justify buffer stocks.

• The cost of a stockout: if running out stops a whole production line or puts lives at risk (a hospital), a large buffer is worth its cost. If customers are willing to wait a day, JIT carries little risk.

• The nature of the product: perishable goods and fast-changing products (fresh food, fashion, electronics) are costly to hold, which favours JIT; durable, standard items can be stored cheaply.

• Predictability of demand: stable demand suits JIT; seasonal or volatile demand may need stock built up in advance.

• Finance and space: JIC needs cash and storage space; a business with weak liquidity may not be able to afford it.

• The state of the economy and the risk environment: in periods of disruption (pandemics, conflict, tariffs) many businesses move towards JIC for critical items; in stable periods the pressure to cut costs pushes them back towards JIT.

In practice most businesses combine the two. A common approach is to use JIT for cheap, standard parts available from many local suppliers, and to hold a buffer of critical, hard-to-replace parts from distant or single suppliers. Toyota's stockpile of chips before the semiconductor shortage of 2021 followed this reasoning, because the cost of holding a few months of chips was small compared with the cost of an idle factory. For most businesses the strongest approach is therefore a planned mix of the two, reviewed as risks change.

Stock control

Whatever approach a business takes, it needs a system for deciding when to order stock and how much to order. Holding too much stock raises costs; holding too little risks a stockout, the situation in which the business runs out and cannot produce or sell.

A stockout costs more than the lost sale. Workers and machines may stand idle while fixed costs continue, customers may switch to competitors permanently, and the business may have to pay extra for emergency deliveries. These costs are set against the costs of holding stock when a business plans its stock levels.

The stock control chart

A stock control chart is a simple model of how the stock of one item changes over time. Stock falls as the item is used or sold, and rises suddenly when a delivery arrives. Because use is assumed to happen at a steady rate and deliveries arrive all at once, the stock line has a "sawtooth" shape.

A stock control chart uses six terms. The first, the usage rate, is the speed at which stock is used up.

Buffer stock is the minimum level of stock the business plans to hold at all times, as a safety margin against late deliveries or unexpected increases in usage. In a perfect plan, each delivery arrives just as stock falls to the buffer level, so the buffer is never used.

The lead time is the time between placing an order and receiving the delivery. It includes the time to process the order, make or pick the goods, and transport them.

Because of the lead time, the business must order before stock reaches the buffer level. The reorder level is the stock level at which a new order is placed. It must be high enough to cover all the stock that will be used during the lead time, plus the buffer stock.

The reorder quantity is the amount ordered each time. When the delivery arrives, it lifts stock from the buffer level to the maximum stock level, the highest level of stock the business plans to hold, set by storage space, cost and the risk of the stock going out of date.

The two figures are linked: the maximum stock level is the buffer plus each delivery.

The chart is drawn to scale for a business that uses 100 units a week, holds a buffer of 200 units and orders 600 units at a time, with a lead time of two weeks. Stock starts at the maximum of 800 units and falls by 100 units each week. After four weeks it reaches 400 units, the reorder level, and an order is placed. During the two-week lead time another 200 units are used, so stock is exactly at the buffer of 200 when the delivery of 600 units arrives and lifts it back to 800. The cycle then repeats every six weeks.

The reorder level formula follows directly from the chart. Stock used during the lead time is 100 × 2 = 200 units, and the business wants 200 units left when the delivery arrives, so it must order when stock is 200 + 200 = 400 units.

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Calculating stock levels

Four relationships link the figures on a stock control chart. Given any three of the main values, the others can be calculated:

The units must match: if usage is measured per week, the lead time must be in weeks; if usage is per day, the lead time must be in days. The time between deliveries is the length of one "tooth" of the chart.

What happens when the plan goes wrong

A stock control chart shows a plan. In reality deliveries can be late and usage can change, and the chart can show what happens then. The two panels show the business from the first chart in two situations.

In panel (a) the second delivery arrives one week late, in week 13 instead of week 12. Stock falls below the buffer, to 100 units, before the delivery arrives, and production continues because the buffer covers the delay. Because the delivery of 600 units arrives when stock is 100, the new peak is only 700 units.

In panel (b) the usage rate doubles to 200 units a week. The order is placed at the reorder level as usual, but 400 units are used during the two-week lead time, so the buffer of 200 is used up and stock reaches zero just as each delivery arrives. Any further delay would cause a stockout.

A business that sees its stock repeatedly falling into the buffer should review its plan. It can raise the reorder level (order earlier), raise the buffer stock, increase the reorder quantity, negotiate a shorter lead time, or find a more reliable supplier. Each of these increases stock-holding costs or ordering costs, so the change must be weighed against the cost of stockouts.

Limitations of stock control charts

A stock control chart is a model, and its assumptions limit its use:

• Constant usage: real usage changes with demand, the season and production plans. The straight falling line is an average.

• Constant lead time: suppliers are sometimes late, and global supply chains in particular have variable lead times.

• Deliveries arrive all at once and in full: in practice part-deliveries and faulty items are common.

• One item at a time: a manufacturer may hold thousands of different items, each with its own chart, so the system must be computerised, usually as part of a stock management system that reorders automatically.

• It does not show the cost of holding stock or of ordering, so it cannot by itself say what the best buffer or reorder quantity is.

Despite these limits, the chart is useful because it makes the logic of stock control clear: it shows why a buffer is needed, why orders must be placed before stock runs low, and how changes in usage or lead time affect the risk of a stockout. A JIT business can be shown on the same chart: a very small buffer, a very small reorder quantity and a very short lead time.

Capacity utilisation

Every business has a limit on how much it can produce with its current resources. A factory has a maximum number of units it can make in a month; a hotel has a fixed number of rooms; a hospital has a fixed number of beds and operating theatres. This limit is its capacity.

Capacity utilisation measures how much of that capacity is actually being used. It is expressed as a percentage.

Why capacity utilisation matters: fixed costs per unit

The main reason capacity utilisation matters is the effect on cost per unit. Fixed costs such as rent, salaries of permanent staff and depreciation of machines stay the same whatever the output, so the more units are produced, the more thinly those costs are spread. A business working at high capacity utilisation has a lower average cost per unit, which allows lower prices or higher profit margins.

For example, a factory with fixed costs of $400,000 a month and a capacity of 50,000 units has a fixed cost of $13.33 per unit if it produces 30,000 units (60% capacity utilisation), but only $8.89 per unit at 45,000 units (90%). Raising capacity utilisation from 60% to 90% cuts fixed cost per unit by a third, without any change in efficiency on the factory floor.

Capacity utilisation in the economy

Capacity utilisation also rises and falls with the state of the economy. When demand falls in a recession, businesses produce less, but their factories and machines remain, so utilisation drops.

The chart shows that US manufacturing has rarely used more than 80% of its capacity in the last twenty years. Utilisation fell to 63.5% in June 2009, after the financial crisis, and to 62.5% in April 2020, when factories closed during the pandemic. It recovered quickly after 2020 as demand returned. In August 2026 it stood at about 76%. A sustained period of high utilisation is a signal that businesses may need to invest in new capacity.

Dealing with low capacity utilisation

Spare capacity that lasts for a long time raises unit costs. A business can respond in two ways: raise output to fill the capacity, or reduce the capacity to fit the output.

• Raise demand: lower prices, more promotion, new markets or new products (a ski resort that opens for mountain biking in summer).

• Sell spare capacity to others: make products for other businesses under contract, or rent out unused space or machines.

• Bring work in-house: make components that were previously bought in (the make-or-buy decision).

• Reduce capacity (rationalisation): close a factory, sell machines, reduce shifts or make staff redundant. This lowers fixed costs but is hard to reverse and can damage morale and the business's reputation.

Dealing with capacity utilisation that is too high

When a business is close to full capacity it can:

• Use outsourcing to pass some production to other businesses, at extra cost and with less control over quality.

• Increase the hours worked: overtime, extra shifts or temporary staff, which raise costs per unit and may lower quality if workers are tired.

• Invest in more capacity: a larger factory or more machines. This is expensive and takes time, and it lowers utilisation again until demand grows into the new capacity.

• Raise prices, which reduces demand and raises profit per unit, or turn away orders, which risks losing customers to competitors.

Which response is best depends on whether the change in demand is temporary or permanent. A temporary peak is best handled with overtime or outsourcing; a lasting rise in demand justifies investment in new capacity. Investing too early leaves the business with high fixed costs and spare capacity, while investing too late means lost orders and customers who may move to competitors.

Defect rate

A defect is a unit of output that does not meet the required standard and must be scrapped, reworked or sold at a lower price. Every defect wastes materials, labour and machine time, and defects that reach customers damage the business's reputation. The defect rate measures how often this happens.

The defect rate is a measure of quality, and of efficiency too, because defects waste resources. A falling defect rate usually means lower costs per good unit, fewer customer complaints and returns, and less waste going to landfill, which links it to environmental sustainability. Businesses reduce defect rates through better training, maintenance, more reliable suppliers, automation and quality management methods such as total quality management and kaizen.

Acceptable defect rates differ greatly between industries. A clothing factory may tolerate a few per cent of seconds, while makers of medical devices or aircraft parts aim for almost zero. The quality method Six Sigma, developed at Motorola, sets a target of no more than 3.4 defects per million opportunities, which shows how small the rate must be when the cost of a defect is very high.

Sources: Motorola; G. Tennant, Six Sigma: SPC and TQM in Manufacturing and Services, 2001 (via Wikipedia, "Six Sigma", 2026).

Measuring productivity

Productivity is the general idea of how much output a business gets from its inputs. A business can measure it in several ways, depending on which input it wants to judge. The three main measures are labour productivity, capital productivity and the productivity rate.

Labour productivity

Labour productivity measures output per unit of labour. The labour input can be the number of workers or the number of hours worked. Hours give a fairer measure when some staff work part-time or overtime.

Labour productivity rises when workers are better trained, better motivated or better equipped, or when work is better organised. It is the most widely used measure because labour is the largest cost in many businesses, especially in services.

Capital productivity

Capital productivity measures output per unit of capital, such as per machine, per machine hour or per dollar invested in equipment. It shows how well a business uses its machinery and equipment, which matters most in capital-intensive businesses such as car plants, chemical works and data centres.

Capital productivity rises when machines run for longer (more shifts, less downtime), run faster, or are replaced by more advanced technology. It falls when machines stand idle, which links it closely to capacity utilisation.

Productivity rate

Labour and capital productivity each measure one input. The productivity rate compares total output with all the inputs used. Because outputs and inputs are of different kinds (loaves, workers, flour, electricity), both are normally measured in money: the value of output and the cost of all the inputs.

Interpreting productivity measures

A single productivity figure is of limited use. It becomes useful when compared over time (is the business improving?), with targets, or with competitors and other branches (benchmarking). A rise in productivity lowers the cost of each unit, which supports lower prices, higher margins or higher wages.

Each measure also has limits:

• Quantity, not quality: a worker who rushes may produce more but with more defects. Productivity figures should be read together with the defect rate and customer satisfaction.

• Partial measures: labour productivity can rise simply because the business has bought new machines, not because workers are working better. Comparing labour productivity between a highly automated factory and a labour-intensive one is misleading.

• Measuring output in services is difficult: the output of a teacher, nurse or consultant is hard to count, and counting patients seen or calls answered may encourage staff to rush.

• Prices affect value measures: the productivity rate rises if selling prices rise or input prices fall, even if nothing changes physically.

• Ethical limits: pressure to raise productivity can lead to stress, unsafe work and close monitoring of staff. Businesses face ethical questions when productivity targets damage employee well-being.

Operating leverage

Businesses differ in their cost structure: the mix of fixed and variable costs in their total costs. A software company has very high fixed costs (developers, data centres) and almost no variable cost for each extra copy sold. A taxi firm whose drivers are paid a share of each fare has mostly variable costs. This difference has a large effect on how profit responds to a change in sales.

The reason lies in contribution. Each extra unit sold adds its contribution per unit (price minus variable cost per unit) to profit. In a business with high fixed costs and low variable costs, the contribution per unit is large, so each extra sale adds a lot to profit once fixed costs are covered, and each lost sale removes a lot. In a business with low fixed costs and high variable costs, each unit adds little contribution, so profit changes more slowly.

The size of the effect is measured by the degree of operating leverage (DOL), which compares the percentage change in profit before interest and tax (PBIT) with the percentage change in sales revenue that caused it.

A DOL of 4 means that a 1% change in sales revenue causes a 4% change in PBIT, in the same direction. The higher the DOL, the more sensitive profit is to changes in sales.

The graph plots each business's PBIT against its sales revenue. The slope of each line is the contribution per dollar of sales: $0.80 for Arcline and $0.40 for Bramble. The steeper line belongs to the business with higher operating leverage. Both lines pass through the same point at $1 million of sales; to the right Arcline earns more, to the left it earns less. Arcline's line crosses zero at $750,000 of sales and Bramble's at $500,000, so Arcline starts to make a loss sooner.

Evaluation: high or low operating leverage?

High operating leverage is an advantage when sales are growing: profit rises much faster than sales, as in software, telecommunications and pharmaceuticals, where each extra sale costs little to produce. It is a risk when sales fall, because fixed costs must still be paid. Airlines, car makers, steel producers and hotels have high fixed costs and suffer large losses in recessions; many airlines needed state support when demand collapsed in 2020.

A business can reduce its operating leverage by turning fixed costs into variable costs: renting equipment only when needed, outsourcing production, paying staff partly by commission or using temporary workers. This lowers risk but also lowers the profit gained from extra sales, and it may reduce control over quality. The right cost structure depends on how stable and predictable demand is, how much the business can afford to lose in a bad year, and the stage of the business cycle: in a growing market high operating leverage pays off, while in an uncertain one flexibility is worth more.

Cost to buy and cost to make

Every manufacturer must decide which parts and services to produce itself and which to buy from other businesses. A furniture maker can make its own drawer handles or buy them; a school can run its own canteen or pay a catering company; a car maker can design its own software or license it. This is the make-or-buy decision, also called make or buy analysis. The first step is to compare two costs.

The cost to buy (CTB) is simply what the business would pay a supplier for the quantity it needs.

The cost to make (CTM) is the total cost of producing the same quantity in-house: the fixed costs of making it (equipment, supervision, space) plus the variable costs of each unit.

On purely financial grounds, the business should make the item if CTM is lower than CTB, and buy it if CTB is lower. Because CTM includes fixed costs, making is usually cheaper only at large quantities, when the fixed costs are spread over many units.

The graph shows why the decision depends on quantity. The CTB line starts at zero because nothing is paid if nothing is bought, but it is steeper because each unit costs more. The CTM line starts at $120,000 because the fixed costs must be paid whatever the quantity. The lines cross where the two costs are equal; at higher quantities making is cheaper.

Qualitative factors in the make-or-buy decision

The lower-cost option is not automatically the right choice. Several qualitative factors can outweigh a cost difference, especially a small one like Kettle & Co's $20,000.

Other factors include the opportunity cost of the capital and space used for making, the reliability of the cost estimates (the CTM is a forecast; the supplier's price is usually fixed in a contract), the ethical record of potential suppliers, and the environmental effect of transport. The Chinese car maker BYD makes its own batteries through its FinDreams subsidiaries, which gives it control over its most important component, while most car makers buy batteries from specialist producers and so need less capital and can switch suppliers.

Sources: BYD Company; Wikipedia, "BYD Company" and "FinDreams" (2026).

Evaluation: should a business make or buy?

The CTB and CTM figures give a clear starting point, but the decision depends on more than one year's costs. A business should make a component when the quantity needed is large and stable, when the component is critical to quality or to the product's identity, and when it has the skills and capital. It should buy when quantities are small or uncertain, when specialist suppliers are more efficient, and when it wants to keep its fixed costs and operating leverage low.

Make-or-buy decisions are also strategic. Buying links the business to the wider issues of outsourcing and offshoring, with the same trade-off between cost and control. Making is a form of vertical integration that can protect supply but makes the business less flexible. The 2021 chip shortage pushed several car makers towards closer control of critical parts, while many still buy most components, which shows that the balance changes with the risks a business faces. A deeper method of making this decision, using contribution and the fixed costs that would remain either way, belongs to contribution costing.

Production planning and the key concepts

The table shows that production planning decisions are rarely only about cost. The same choice, for example to hold more stock, can make a business more resilient to change but less efficient and, if stock is wasted, less sustainable.

Case study: the semiconductor shortage in car making

A modern car can contain more than a thousand semiconductor chips, controlling everything from the engine and brakes to the windows and the screen. Car makers had long bought chips through their tier 1 suppliers and run lean, JIT supply chains with little stock. The global chip shortage of 2020–2023 tested these supply chains severely, and it showed the difference between JIT and JIC in practice.

What happened

In early 2020, as the pandemic began, car makers expected sales to fall and cancelled chip orders. Chip makers moved their capacity to computers and other consumer electronics, for which demand was rising as people worked and studied at home. When car sales recovered faster than expected later in 2020, the chip makers were working close to full capacity utilisation, and building new capacity takes years. Further shocks followed: in March 2021 a fire damaged a plant of Renesas Electronics, a major supplier of the microcontrollers used in cars, which expected a return to normal production to take at least 100 days.

Car makers with little stock had to stop production. By March 2021 Volkswagen, General Motors, Ford, Honda and Stellantis, among others, had been forced to slow or suspend production. Ford parked thousands of unfinished vehicles, waiting for chips, at the Kentucky Speedway racetrack. As the shortage lasted, estimates of its cost grew.

Sources: AlixPartners, press release, 23 September 2021.

The table shows that the expected loss of output almost doubled within four months. For businesses with high operating leverage, such as car makers with expensive plants and permanent workforces, each idle week meant fixed costs with no matching contribution.

Toyota's buffer of chips

Toyota, the company most associated with JIT, coped better than most of its rivals in early 2021. After the 2011 earthquake, when it estimated that its supply of more than 1,200 parts and materials might be affected, it drew up a list of 500 priority items needing secure supply. Under its business continuity plan, it required suppliers to stockpile between two and six months' worth of chips, depending on the time from order to delivery. In February 2021, while rivals were cutting output, Toyota raised its full-year earnings forecast by 54%.

This is just-in-case applied to a small number of critical, hard-to-replace components inside a JIT system. Chips have long lead times and come from a few specialised suppliers far away, so the cost of a stockout (a whole factory standing idle) is very high compared with the cost of holding the chips, which are small and do not go out of date quickly. In stock control terms, Toyota had a much larger buffer stock for chips than for other parts.

The limits of the buffer

A buffer stock covers a shortage only for as long as the stock lasts, and only for the parts that are stockpiled. In August 2021, as COVID-19 spread through Southeast Asia, where many of its parts suppliers are located, Toyota announced that it would cut its planned global output for September by about 360,000 vehicles, cutting production in Japan by 40%. In September it announced further cuts of 70,000 vehicles in September and 330,000 in October, and lowered its production forecast for the year to March 2022 from 9.3 million to 9 million vehicles.

The chart shows that the cut affected Toyota plants on every continent, because they share suppliers in Southeast Asia and Japan. The stockpile protected Toyota against a shortage of chips, but not against the closure of suppliers of other parts, for which it held little stock.

Over the whole of 2021, the difference still showed. In the United States, Toyota sold 2.332 million vehicles, up 10%, while General Motors sold 2.218 million, down 13%, with fourth-quarter sales down 43%. It was the first full year since 1931 that General Motors had not been the best-selling car maker in the United States.

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How car makers changed their supply chain management

The shortage led car makers to rethink their supply chains. In September 2021 General Motors said it would source more chips directly from chip makers rather than through its suppliers.

In November 2021 Ford announced a partnership with the chip maker GlobalFoundries to increase chip supply, and in February 2023 General Motors agreed a deal for GlobalFoundries to dedicate part of a New York factory to its chips. In 2024 Toyota agreed to invest in a second plant built by TSMC in Kumamoto, Japan. These moves combine closer supply chain management (dealing with tier 2 and tier 3 suppliers directly), longer-term commitments that give chip makers the confidence to add capacity, and a step towards making rather than simply buying.

What the case shows, and its limits

The case shows that JIT and JIC are not opposites a business must choose between. Toyota kept JIT for most parts and used JIC for the critical items where a stockout would be most costly, and that combination protected its output for longer than its rivals'. It also shows the value of supply chain management that looks beyond tier 1 suppliers, and how capacity limits at one stage of a global supply chain (the chip makers) can stop production at every later stage.

The case has limits. Toyota's advantage was partly temporary, as its own cuts in late 2021 show, and the figures for lost output are estimates by a consulting firm, not measured totals. Sales figures also reflect other factors, such as each company's range of models and its pricing. Finally, a large buffer has costs that are easy to ignore after a crisis: in a period without disruption, the money tied up in chips would have been an unnecessary cost.

• Explain why holding a buffer stock of chips helped Toyota in early 2021.

• Analyse the factors that made chips more suitable for just-in-case than other car parts.

• To what extent should car makers move from JIT to JIC after the chip shortage?

Sources: Autocar, 20 September 2021 (chips per car); AlixPartners, press release, 23 September 2021; Reuters, "How Toyota thrives when the chips are down", 9 March 2021, and "Toyota dethrones GM as U.S. sales leader", 4 January 2022 (via Nippon.com); Associated Press, 19 August 2021 and 10 September 2021; Reuters, 31 March 2021 (Renesas fire), 18 November 2021 (Ford and GlobalFoundries); AP, 10 February 2023 (GM and GlobalFoundries); Nikkei Asia, 6 February 2024 (Toyota and TSMC).

Exam practice

Production planning appears in Paper 2 at HL, where calculations from the stimulus are often followed by "comment on your answer" or by an extended response. Stock control charts may have to be constructed, and supply chain and JIT/JIC questions often appear in Paper 3 when a social enterprise depends on suppliers.

Calculation questions on stock levels often give the data in days rather than weeks. Keep the units consistent throughout.

Operating leverage questions test both the calculation and its meaning for risk.

Paper 3 can ask how a social enterprise should organise its supply chain. Answers should weigh cost against reliability and the enterprise's social mission.

Summary

• A supply chain links raw material producers, suppliers, manufacturers, distributors, retailers and consumers; logistics moves and stores the goods, and supply chain management coordinates the whole chain.

• Global supply chains offer lower costs and wider choice but bring long lead times and greater exposure to disruption than local ones.

• JIT minimises stock and its costs but has no buffer against disruption; JIC holds large stocks for security at a higher cost. Most businesses combine them.

• A stock control chart shows stock falling at the usage rate and rising with each delivery; reorder level = buffer stock + (usage rate × lead time) and reorder quantity = maximum stock level − buffer stock.

• Capacity utilisation rate = (actual output ÷ productive capacity) × 100; higher utilisation spreads fixed costs, but 100% leaves no flexibility. Defect rate = (defective units ÷ total units) × 100.

• Labour productivity and capital productivity measure output per unit of one input; the productivity rate = (total output ÷ total input) × 100.

• Operating leverage is high when fixed costs are a large share of costs; the degree of operating leverage = % change in PBIT ÷ % change in sales revenue.

• CTB = price × quantity and CTM = fixed costs + (average variable cost × quantity); the make-or-buy decision also weighs quality, reliability, flexibility, expertise and risk.

Self-check

• To do:

  I can explain the stages of a supply chain and the difference between logistics and supply chain management.

• To do:

  I can compare local and global supply chains and explain the causes of supply chain disruption.

• To do:

  I can evaluate JIT and JIC for a given business and reach a justified judgment.

• To do:

  I can construct and interpret a stock control chart with lead time, buffer stock, reorder level and reorder quantity.

• To do:

  I can calculate the reorder level, reorder quantity and maximum stock level.

• To do:

  I can calculate and comment on the capacity utilisation rate and the defect rate.

• To do:

  I can calculate labour productivity, capital productivity and the productivity rate, and explain their limits.

• To do:

  I can explain operating leverage and calculate the degree of operating leverage.

• To do:

  I can calculate CTB and CTM and recommend whether to make or buy, using qualitative factors.