Lecture 4 The Vertical Boundaries of the Firm: Make vs. Buy

Transcription

1 Lecture 4 The Vertical Boundaries of the Firm: Make vs. Buy 1

2 Overview Make vs. Buy Upstream, downstream Defining boundaries Some make-or-buy fallacies Reasons to buy Reasons to make Summarizing make or buy decision 2

3 What Does Make or Buy Mean? Refers to the vertical chain of production Begins with acquisition of raw materials Ends with sale of final product In addition to materials, this process also includes support services such as finance, marketing and sales Organization of vertical chain is important part of business strategy 3

4 Make or Buy Explained Further Firms use intermediate products and services in their production process Which 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 4

5 Make-or-Buy Continuum Arm s length market transactions Long-term contracts Strategic alliances and joint ventures Parent / subsidiary relationships Perform activity internally Less integrated More integrated Buy Make 5

6 Examples Examples of firms that make Honda Exxon Mobil Examples of firms that buy Toyota Adidas, Nike Apple 6

7 Make versus Buy Considerations Decision depends on costs and benefits of each Need to consider ALL benefits and costs Think about opportunity costs Intermediate solutions are possible Strategic alliances with vendors Joint ventures Franchises 7

8 More Make versus Buy Considerations Economies of scale achieved by firm versus market Value of market discipline Ease of co-ordination of production flows in-house Transaction costs when dealing with market 8

9 Make or Buy Fallacies Firms should make an asset, rather than buy it, if the asset is the source of competitive advantage Firms should buy, rather than make, to avoid the cost of making the product 9

10 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 10

11 Reasons to Buy Patents/proprietary information other unique situations that makes low-cost production possible Economies of scale unavailable to inhouse units Market discipline versus ability of in-house units to hide their inefficiencies behind overall corporate success Book calls these agency and influence costs 11

12 Economies of Scale Again Consider IMG Tennis Academy run by Nick Bollettieri in Bradenton, FL They produce tennis players They can make tennis balls or buy them from the market 12

13 IMG Tennis Academy C Average cost C* Q Q* Quantity of tennis balls 13

14 IMG Tennis Academy (Continued) Suppose the Academy only uses Q tennis balls They 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 ) 14

15 Economies of Scale (Continued) IMG Tennis Academy could make Q* tennis balls, but competing tennis academies would rather buy from independent seller than competitor An 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 15

16 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 16

17 Economies of Scale (Continued) Insurance provides another example of make or buy and economies of scale Firms 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 17

18 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 firm Others 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 connections 18

19 Agency Costs The incentives to be efficient and innovative are weaker when a task is performed in-house Agency costs are particularly problematic if the task is performed by a cost center within an organization It is difficult to internally replicate the incentives faced by market firms 19

20 Influence Costs In addition to agency costs, performing a task in-house will lead to influence costs as well Internal Capital Markets allocate scarce capital Allocations can be favorably affected by influence activities Resources consumed by influence activities represent influence costs 20

21 Reasons to Make Costs imposed by poor coordination Reluctance of partners to develop and share valuable private information Transactions costs that can be avoided by performing the task in-house Each problem can be traced to difficulties in contracting 21

22 Contracts Firms often use contracts when certain tasks are performed outside the firm A complete contract protects each party to a transaction from opportunistic behavior of other(s) Most real-life contracts are incomplete 22

23 Reasons for Incomplete Contracts Bounded rationality Individuals cannot foresee all possible contingencies Difficulties in specifying/measuring performance Hard to define normal wear and tear Asymmetric information One party can misrepresent information with impunity 23

24 Contract Law Established contract law helps facilitate transactions Traditions established by the court regarding who is responsible for what In 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

25 Contract Law Still remains vague and open to different interpretations resulting in litigation Litigation is costly and can hurt or break a relationship 25

26 Coordination Problems For successful coordination one party needs to make decisions that depend on the decision made by others A good fit should be accomplished in several dimensions, such as: Timing Size Color Sequence 26

27 Coordination Problems (Continued) Without good coordination, bottlenecks arise in the production process Coordination is especially important when design attributes are present To ensure coordination, firms rely on contracts that specify delivery dates, design tolerances and other performance targets 27

28 More on Design Attributes Design attributes are attributes that need to relate to each other precisely Small errors in design attributes are extremely costly If coordination is critical, administration control may replace the market mechanism Design attributes may be moved in-house 28

29 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 29

30 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 information In practice noncompete clauses can be hard to enforce 30

31 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 costs Outsourcing entail costs of negotiating, writing and enforcing contracts 31

32 Transactions Costs (Continued) Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behavior Transactions costs explain why economic activities occur outside the price system Sources of transactions costs Investments in relationship-specific assets Rents and quasi-rents Holdup problem 32

33 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 agreement Examples 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 33

34 Forms of Asset Specificity Relationship-specific assets may exhibit different forms of specificity Site specificity Physical asset specificity Dedicated assets Human asset specificity 34

35 Rent and Quasi-rent The term rent denotes economic profits profits after all the economic costs, including the cost of capital, are deducted Quasi-rent is the excess economic profit from a transaction compared with economic profits available from an alternate transaction 35

36 Rent and Quasi-rent Example Baa Goat Farm has agreed to sell goat milk to Feta Feta Cheese and receive revenue of R 1 Baa incurs total variable costs of C to produce the cheese Feta Feta also requires Baa to process the milk using a special piece of equipment that rents for I. 36

37 Rent and Quasi-rent Example If Baa Goat Farm sells milk to Feta Feta Cheese they earn an economic profit of π 1 = R 1 - 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 R 2 and their economic profit will be π 2 = R 2 - C 37

38 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 (π 1 ) 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 (π 1 - π 2 ) 38

39 The Holdup Problem Whenever π 1 > π 2, Feta Feta can benefit by holding up Baa Goat and capturing the quasi-rent for itself A complete contract will not permit the breach With incomplete contracts and relationship-specific assets, quasi-rent may exist and lead to the holdup problem 39

40 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 40

41 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 41

42 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 42

43 Holdup and Underinvestment When there is a holdup, the investment made in relationship-specific assets loses value Anticipating holdups, firms will make otherwise sub-optimal level of investments and suffer higher production costs 43

44 Asset Specificity and Transactions Costs Summary Relationship-specific assets support a particular transaction Redeploying to other uses is costly Quasi-rents become available to one party and there is incentive for a holdup Potential for holdups lead to Underinvestment in these assets Investment in safeguards Reduced trust 44

45 The Make-or-Buy Decision Tree 45

46 Example Gatton College Building Use the current renovation and expansion of the Gatton College building on UK campus to illustrate some of these issues Renovating and expanding our existing building Total cost $65M entirely privately financed (no money from the state of Kentucky) We are buying this work not making it 46

47 Example Gatton College Building 47

48 View from South Limestone

49 View of New Campus Entry

50 Atrium View - South

51 Atrium View North

52 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 52

53 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 53

54 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? 54

55 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 users A fundamental question is which parts of the chain of production a firm should perform itself and which parts it should purchase from the market 55

56 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 service 56