Lecture 4The Vertical Boundaries of the Firm:

Make vs. Buy

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Overview

Make vs. Buy– Upstream, downstream– Defining boundaries– Some make-or-buy fallacies

Reasons to buyReasons to “make”Summarizing make or buy decision

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What Does “Make or Buy” Mean?

Refers to the “vertical chain of production”Begins with acquisition of raw materialsEnds with sale of final productIn addition to materials, this process also

includes support services such as finance, marketing and salesOrganization of “vertical chain” is

important part of business strategy

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“Make or Buy” Explained Further

Firms use intermediate products and services in their production processWhich of these should be performed inside

the firm?Which of these should be out-sourced?In other words, choice is between internal

market or external market

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Make-or-Buy Continuum

Arm’s length markettransactions

Long-term contracts

Strategic alliances and joint ventures

Parent / subsidiary relationships

Performactivity internally

Lessintegrated

More integrated

Buy Make

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Examples

Examples of firms that “make”– Honda– Exxon Mobil

Examples of firms that “buy”– Toyota– Adidas, Nike– Apple

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Make versus Buy Considerations

Decision depends on costs and benefits of eachNeed to consider ALL benefits and costsThink about opportunity costsIntermediate solutions are possible

– Strategic alliances with vendors– Joint ventures– Franchises

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More Make versus Buy ConsiderationsEconomies of scale achieved by firm

versus “market”Value of market disciplineEase of co-ordination of production flows

in-houseTransaction costs when dealing with

“market”

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Make or Buy Fallacies

Firms should make an asset, rather than buy it, if the asset is the source of competitive advantageFirms should buy, rather than make, to

avoid the cost of making the product

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Make or Buy Fallacies

Firms should make, rather than buy, because a vertically integrated producer can avoid paying a high price for the product during period of peak demand or scare supply (Can obtain an input at “cost”)Firms should make rather than buy to tie

up a distributional channel and gain market share from rivals

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Reasons to Buy

Patents/proprietary information other unique situations that makes low-cost production possibleEconomies of scale unavailable to in-

house unitsMarket discipline versus ability of in-house

units to hide their inefficiencies behind overall corporate success– Book calls these agency and influence costs

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Economies of Scale Again

Consider IMG Tennis Academy run by Nick Bollettieri in Bradenton, FLThey “produce” tennis playersThey can make tennis balls or buy them

from “the market”

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IMG Tennis Academy

Quantity of tennis balls

Aver

age

cost

C*

C’

Q*Q’

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IMG Tennis Academy (Continued)

Suppose the Academy only uses Q’ tennis ballsThey could manufacture tennis balls

themselves at an average cost of C’Or they could buy them from the market,

where a large firm manufacture them at a cost of C* (and probably sell them to the Academy for less than C’)

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Economies of Scale (Continued)

IMG Tennis Academy could make Q* tennis balls, but competing tennis academies would rather buy from independent seller than competitorAn outside supplier may reach the

minimum efficient scale (MES) by supplying to different tennis academies– MES may be feasible for independent supplier

but not for individual tennis academies

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Economies of Scale (Continued)

Will the outside supplier charge C* (its average cost) or C’ (the average cost for the manufacturer for in-house production)?The answer depends on the degree of

competition faced by the supplier

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Economies of Scale (Continued)

Insurance provides another example of make or buy and economies of scaleFirms can hire outside insurance or can

“self-insure”Book example – British Petroleum

– BP self-insures for large losses but buys insurance for small losses

– Small losses are relatively common so outside firms can utilize economies of scale

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Make vs Buy Employee Skills

Some firms provide specific training for their employees when they start work– McKinsey; Acenture– Can provide training tailored to the needs of

the firmOthers buy workers that have been trained

by other firms such as Universities– Buy employees who already have MBA– MBAs interact with others in the course

developing connections18

Agency Costs

The incentives to be efficient and innovative are weaker when a task is performed in-houseAgency costs are particularly problematic

if the task is performed by a “cost center” within an organizationIt is difficult to internally replicate the

incentives faced by market firms

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Influence Costs

In addition to agency costs, performing a task in-house will lead to “influence costs” as well“Internal Capital Markets” allocate scarce

capitalAllocations can be favorably affected by

influence activitiesResources consumed by influence

activities represent “influence costs”

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Reasons to Make

Costs imposed by poor coordinationReluctance of partners to develop and

share valuable private informationTransactions costs that can be avoided by

performing the task in-houseEach problem can be traced to difficulties

in contracting

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Contracts

Firms often use contracts when certain tasks are performed outside the firmA “complete” contract protects each party

to a transaction from opportunistic behavior of other(s)Most “real-life” contracts are incomplete

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Reasons for Incomplete Contracts

Bounded rationality– Individuals cannot foresee all possible

contingenciesDifficulties in specifying/measuring

performance– Hard to define “normal wear and tear”

Asymmetric information– One party can misrepresent information with

impunity

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Contract Law

Established contract law helps facilitate transactions– Traditions established by the court regarding

who is responsible for whatIn the U.S. we have common law and

Uniform Commercial Code– Establish standard provisions for variety of

transactions so we don’t need a contract every time we transact

– No similar Code in Europe 24

Contract Law

Still remains vague and open to different interpretations resulting in litigationLitigation is costly and can hurt or break a

relationship

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Coordination Problems

For successful coordination one party needs to make decisions that depend on the decision made by othersA good fit should be accomplished in

several dimensions, such as: – Timing– Size– Color– Sequence

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Coordination Problems (Continued)

Without good coordination, bottlenecks arise in the production processCoordination is especially important when

“design attributes” are presentTo ensure coordination, firms rely on

contracts that specify delivery dates, design tolerances and other performance targets

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More on Design Attributes

Design attributes are attributes that need to relate to each other preciselySmall errors in design attributes are

extremely costlyIf coordination is critical, administration

control may replace the market mechanismDesign attributes may be moved in-house

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Design Attributes or Not?

Design attributes– Course sequence in mathematics curriculum– Proper placement of beer label on bottle– Proper refrigeration of ice cream in Graters

Not design attributes– Course sequence of economics electives– Timely delivery of 10-year old bourbon– Proper arrangement of ice cream in Graters

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Leakage of Private Information

Firms would not want to compromise the source of their competitive advantage Well-defined patents can help but may not

provide full protection Contracts with noncompete clauses can

be used to protect against leakage of informationIn practice noncompete clauses can be

hard to enforce

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Transactions Costs

If the market mechanism improves efficiency, why do so many of the activities take place outside the price system? (Coase)Costs of using the market that are saved

by centralized direction – transactions costsOutsourcing entail costs of negotiating,

writing and enforcing contracts

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Transactions Costs (Continued)

Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behaviorTransactions costs explain why economic

activities occur outside the price systemSources of transactions costs

– Investments in relationship-specific assets– Rents and quasi-rents– Holdup problem

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Relationship Specific Assets

Relationship-specific assets are essential for a given transaction– Costly to redeploy for another transaction– Once asset is in place, other party “locked” into

agreementExamples

– An aluminum refiner invests in a refinery designed to process a particular grade of bauxite ore

– French government invests in transportation infrastructure for Euro-Disney

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Forms of Asset Specificity

Relationship-specific assets may exhibit different forms of specificity– Site specificity– Physical asset specificity– Dedicated assets– Human asset specificity

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Rent and Quasi-rent

The term “rent” denotes economic profits –profits after all the economic costs, including the cost of capital, are deductedQuasi-rent is the excess economic profit

from a transaction compared with economic profits available from an alternate transaction

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Rent and Quasi-rent Example

Baa Goat Farm has agreed to sell goat milk to Feta Feta Cheese and receive revenue of R1

Baa incurs total variable costs of C to produce the cheeseFeta Feta also requires Baa to process the

milk using a special piece of equipment that rents for I.

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Rent and Quasi-rent Example

If Baa Goat Farm sells milk to Feta FetaCheese they earn an economic profit of π1 = R1 - C - I

If Feta Feta were to renege on the agreement and Baa Goat is forced to sell its output in the open market, they can earn revenue of R2 and their economic profit will be π2 = R2 - C

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Rent and Quasi-rent Example (Continued)Rent is the economic profit Baa Goat

expects to earn when they enter into this agreement with Feta Feta (π1)Quasi-rent is the economic profit in excess

profit Baa Goat earns if the deal with Feta Feta goes as planned and they don’t have to sell their cheese on the open market (π1- π2)

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The Holdup Problem

Whenever π1 > π2, Feta Feta can benefit by holding up Baa Goat and capturing the quasi-rent for itselfA complete contract will not permit the

breachWith incomplete contracts and

relationship-specific assets, quasi-rent may exist and lead to the holdup problem

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Effect on Transactions Costs

The holdup problem raises the cost of transacting – Contract negotiations become more difficult– Investments to improve the ex-post

bargaining position– Potential holdup can cause distrust– There could be underinvestment in

relationship-specific assets

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Holdup and Costly Safeguards

Potential for holdup may lead parties to invest in wasteful protective measures– Manufacturer may acquire standby production

facility for an input that is to be obtained from a market firm

– Floating power plants are used in place of traditional power plants to avoid site-specific investments

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Holdup and Distrust

Potential holdups cause distrust between parties and raise the cost of transactions– Distrust can make contracting more costly

since contracts will have to be more detailed– Distrust affects the flow of information needed

to achieve production efficiencies

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Holdup and Underinvestment

When there is a holdup, the investment made in relationship-specific assets loses valueAnticipating holdups, firms will make

otherwise sub-optimal level of investments and suffer higher production costs

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Asset Specificity and Transactions Costs – SummaryRelationship-specific assets support a

particular transactionRedeploying to other uses is costlyQuasi-rents become available to one party

and there is incentive for a holdupPotential for holdups lead to

– Underinvestment in these assets– Investment in safeguards– Reduced trust

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The Make-or-Buy Decision Tree

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Example—Gatton College Building

Use the current renovation and expansion of the Gatton College building on UK campus to illustrate some of these issuesRenovating and expanding our existing

buildingTotal cost $65M entirely privately financed

(no money from the state of Kentucky)We are buying this work not making it

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Example—Gatton College Building

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View from South Limestone

View of New Campus Entry

Atrium View - South

Atrium View – North

Example—Gatton College Building

Coordination among principles involved– Owner—University of Kentucky & Gatton

College of Business and Economics– Design Team—RAMSA and RTA– Contractor—Skanska – Lots of subcontractors– Commissioning Agent—makes sure

everything works

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Example—Gatton College Building

Issues involved– Initial purchasing of services—contracting,

transaction costs – Site preparation work and change orders—

hold up and transaction costs– Work need to be staged in a specific order—

coordinating and sequencing; hold-up– Materials need to meet specifications—

Design attributes

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Example—Gatton College Building

Issues involved– Systems need to work when job is completed;

hire a commissioning agent—transaction costs, costly safeguards

– Job needs to be completed on time—specify date in contract; transaction costs, contingencies?

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Summary

Vertical chain of production starts with the acquisition and processing of raw materials used in production of a good or service and proceeds to the purchase of the good or service by the end usersA fundamental question is which parts of

the chain of production a firm should perform itself and which parts it should purchase from the market

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Summary

Buying from market may be better if:– Proprietary information is needed for input– Economies of scale exist for input– In-house production may lead to agency costs

Making internally may be better if:– Coordination problems are excessive, costly– Private information needs to be shared– Transactions costs can be avoided by making

the good or service56