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 Vertical Boundaries: The Vertical Chain of Aluminum Production Recycling Bauxite ore Alumina Molten aluminum Ingots Refining Smelting Casting / Alloying Initial fabrication Plate Sheet Foil Wire Rod Bar Final goods (examples) Further fabrication Transportation, Building and Construction, Machinery, Containers and Packing, Etc.

4 Supply chain management Operational: management of the flow of goods and services in the firm s production process, including the movement and storage of raw materials, work-in-process inventory, and finished goods from point of origin to point of consumption. Tactical: systematic coordination of traditional business functions within a particular company and across businesses within the vertical chain of production, for the purpose of optimizing the long-term performance of the individual companies and the supply chain as a whole. Strategic: how to organize the vertical chain of production, determining which activities the firm will carry out itself as opposed to purchasing from independent firms in the marketplace. This will be our focus!

5 The Value Chain: how much value is added from raw material suppliers to retail purchase price?

6 In September last year [2015] Alcoa Inc, a global leading aluminium producer by revenue, announced that it would split into two separate companies. One company will retain the Alcoa name and primary aluminium business while the other, yet to be named, will house Alcoa s value-added business. Alcoa s CEO hopes that the move will unlock shareholder value and will result in a generally positive outcome for the company as a whole.

7 Vertical Boundaries: The Vertical Chain of Aluminum Production Recycling Bauxite ore Alumina Molten aluminum Ingots Refining Smelting Casting / Alloying Initial fabrication Plate Sheet Foil Wire Rod Bar Final goods (examples) Further fabrication Transportation, Building and Construction, Machinery, Containers and Packing, Etc.

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10 Make or Buy? Firms use raw materials, machinery and equipment, energy, human resources, intermediate goods, etc. etc. in their production processes. How to acquire such inputs? Two alternatives are to make or to buy. Make refers to bringing the supply of the input under the scope of the firm s activities, i.e. make it yourself. Buy refers to acquiring the input by purchasing it from other firms via market transactions. The two extreme cases between two stages in the vertical chain of production are thus complete vertical integration and arm s length spot market transactions. There are, however, intermediate degrees of connection between upstream and downstream:

11 What Does Make or Buy Mean? 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 11

12 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 12

13 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 13

14 Examples Examples of firms that make Honda Exxon Mobil Examples of firms that buy Toyota Adidas, Nike Apple 14

15 Make vs. Buy Why is this important? What does all this have to do with my ability to get McDonald s French fries when I want them: ching/eco411/articles/trains in Vain_ Epic CSX Traffic Jam Snarls Deliveries, From Co.pdf 15

16 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 16

17 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 17

18 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 Firms should make rather than buy to avoid paying a profit margin to an independent firm 18

19 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 19

20 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 20

21 Advantages of using the market: Economies of Scale Sometimes there are scale economies in producing an input that would not be exhausted by the firm s usage of the input. Toyota s problem: make its own tires or purchase them from third-party suppliers? Until now, the only way out of this dilemma has been to aim to become the lowest cost producer in the industry. The solution was seen to be the establishment of large operations taking advantage of economies of scale. Goodyear's Lawton plant has a capacity of 20 million tyres per year and in Korea, Kumho has built a plant at Kwangju with a capacity of 18 million tyres whilst Hankook has gone even bigger with its Daejon plant capable of 23 million tyres annually. TORRANCE, Calif. (Jan. 5, 2016) Toyota Motor Sales (TMS), U.S.A., Inc., today reported December 2015 sales of 238,350, an increase of 10.8 percent from December 2014 on a volume basis. With two additional selling days in December of 2015, sales were up 2.9 percent on a daily selling rate (DSR) basis. For the year TMS reported sales of 2,499,313 units, a 5.3 percent increase.

22 Toyota s acquisition of tires C Average cost C * LR AC 10m MES Quantity of tires 22

23 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 23

24 IMG Tennis Academy C Average cost C* Q Q* Quantity of tennis balls 24

25 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 ) 25

26 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 26

27 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 27

28 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 28

29 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 29

30 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 30

31 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 31

32 Advantages of using the market: Providing Discipline One final, and perhaps most important, advantage of market acquisition is that markets impose discipline that a firm must replicate with some sort of administrative structure if it chooses to vertically integrate to acquire a particular input. Suppose Toyota decides to vertically integrate and start making rather than buying tires. Can you see any potential problems with locking into supplying your own tires to your auto manufacturing plants? If one of your current tire suppliers tells you about their various problems and wants to raise their prices, what options do you have that you do not if you manufacture your own tires in-house?

33 Advantages of using the market: Providing Discipline Can be true even when we are talking about making a shirt: ching/eco411/articles/penny's Shirts WSJ pdf 33

34 Reasons to Make Production efficiencies 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 Reputation externalities Each problem can be traced to difficulties in contracting 34

35 Reasons for vertical integration: production efficiencies In some production processes, there are physical production efficiencies that make cheek-to-jowl production (with accompanying joint ownership) more efficient. Example: molten aluminum and downstream fabrication. Heat; then let cool; transport; heat again and fabricate; then cool again?? Or just heat it once?

36 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 36

37 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 37

38 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 38

39 Contract Law Still remains vague and open to different interpretations resulting in litigation Litigation is costly and can hurt or break a relationship 39

40 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 40

41 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 41

42 Reasons for vertical integration: extensive coordination Chicken processing plants: Powered by rapid consumption growth, chicken slaughter grew by 4% per year between 1967 and 1992 while turkey slaughter grew 3.7% annually. Nevertheless, the number of turkey plants fell by 60%, while there were only a few more chicken plants in 1992 than there were in For that to happen, plants had to get much bigger: mean plant size in turkey slaughter increased more than sixfold, while the mean size of chicken plants almost tripled.... Organizationally, most poultry slaughter firms adopted an integrated structure in which the integrator, such as Tyson Foods or Perdue, owns the slaughter plant, feed mill, and further processing plants and contracts with a number of poultry growers. The integrator provides the grower with chicks or poults, feed, veterinary services, and other inputs. The grower contributes housing and labor services for raising birds to finished size. Growers frequently maintain long-term relationships with processors Perry, Banker, and Morehart report that their sample of growers had been with the same processor for nine years, on average. [Amer. J. Agr. Econ. 87(1) (February 2005): ] Vertical connection between growers and processors: long-term contracts Contract cattle farming? Poultry and pork operations have grown larger in recent decades to take advantage of lower costs that come with economies of scale. However, the beef business continues to have legions of small operators --- some with fewer than 30 head of cattle --- because the animals require large plots of land for foraging. It's harder to consolidate and manage smaller, more diverse cattle farms and growing operations, so vertical integration isn't practical among beef producers.

43 Reasons for vertical integration: extensive coordination What about making an airplane? ching/eco411/articles/boeing Dreamliner Production WSJ pdf Computers and Software? ching/eco411/articles/companies Vertical WSJ pdf 43

44 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 44

45 Reasons for vertical integration: information asymmetries If the upstream supplier of an input has more information about the quality of an input than the downstream buyer who uses the input in its production process, the buyer is susceptible to exploitation. The input supplier may exploit the buyer by supplying a lower quality product than the buyer was expecting. Vertical integration is one way to eliminate the incentive of the upstream seller to chisel on quality. Example: Gready Foundries and Matsushita. Matsushita contracted with Gready to cast the steel blocks used in its automotive air conditioner compressors. Matsushita then machined and assembled these air conditioner units and supplied them to Toyota, Honda, Mazda, etc. Matsushita guaranteed its compressors for a decade or more. Challenge: How could Matsushita know whether Gready was supplying cast steel blocks that met its very high metallurgical quality standards? Solution: Matsushita paid for Gready to build an extra electric furnace dedicated solely to its compressors, and kept a supervisor on site to oversee the operation.

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47 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 47

48 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 48

49 Reputation externalities Some products involve centralized development of a process, business format, or product, and development and maintenance of the associated brand-name capital. Production and delivery of the product to customers will be decentralized if customers are spread through geographic space. The value of the brand name will depend on customers perception of the quality of their consumption experience. If customers who have a bad experience at one location associate bad quality with the entire chain, there are what we call reputation externalities. Example: you are driving across country, in areas where you have never been. You are hungry and pull off the interstate to get a bite to eat. You have two choices, MacDonald s and Ma s Diner. Which do you choose? Challenge for the owner of the brand name: how to prevent its decentralized suppliers from chiseling on quality at their location and freeriding on the reputation established by everyone else in the chain. Solutions? Vertical integration? Franchising?

50 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 50

51 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 51

52 Reasons for vertical integration: specialized assets Specialized assets: refer to inputs that have significant productivity in a particular use, but little or no value outside of that use. The investment in that asset, once undertaken, is irreversible and so the cost is a sunk cost. Sidebar: are sunk costs relevant for current production decisions? The problem with specialized assets is that the owner of the specialized asset is subject to hold-up, and hence will be reluctant to make the investment in the first place. One solution is vertical integration.

53 Types of asset specificity Site specificity: mine-mouth power plant Physical asset specificity: the doughnut machine Human asset specificity: Gatton s MBA training program vs. UK s employee training programs. Which of these would you be willing to pay for yourself? Dedicated assets: Hopple Plastics and Boston Market plates;tva, Peabody Coal Co., and Big Hog For the musical version of the story:

54 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 54

55 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 milk Feta Feta also requires Baa to process the milk using a special piece of equipment that rents for I. 55

56 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 56

57 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 ) 57

58 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 58

59 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 59

60 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 60

61 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 An Amazon-Disney Dispute Erupts --- In Echo of Hachette Fight, E-Commerce Giant Not Allowing Customers to Pre-Order Some Movies. WSJ 8/11/14. articles/amazon Disney WSJ pdf 61

62 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 62

63 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 63

64 Strategic Alliances and Joint Ventures Strategic alliances involve cooperation, coordination and information sharing for a joint project by the participating firms. A joint venture is an alliance where a new independent organization is created and jointly owned by the promoting firms. 64

65 Strategic Alliances Strategic alliances and joint ventures fall between pure market exchange and full vertical integration. Alliances rely on trust and reciprocity instead of contracts. Disputes are rarely litigated but resolves through negotiation. 65

66 Strategic Alliance - Scenarios Uncertainty surrounding future activities prevents the parties from writing detailed contracts. Transactions are complex and one cannot count on contract law to fill the gaps. Relationship-specific assets give rise to potential holdup problems 66

67 Strategic Alliance - Scenarios It is costly for any one party to develop the necessary expertise. Market opportunity for the transaction is not expected to last very long making a long term contract or merger unattractive. Regulatory environment necessitates acquiring a local partner for the venture 67

68 Strategic Alliances Can Be Difficult Ericsson Joint Venture Looks Like Sony's Show, WSJ, 4/26/01. eco411/articles/ericsson Sony Joint Venture WSJ pdf Sony Buys Ericsson Stake in Handset Joint Venture, WSJ, 10/28/11. eco411/articles/sony Buys Ericsson WSJ pdf 68

69 Collaborative Relationships Traditionally Japanese and Korean industrial firms have been less vertically integrated compared to their western counterparts. Recent trend in the West is vertical disintegration and a focus on core competencies. 69

70 Collaborative Relationships Japanese and Korean firms have organized the vertical chain using long term relationships rather than arm s length transactions Two major types of collaborative relationships are found in Japan Subcontractor networks Keiretsu (Chaebol in Korea) 70

71 Subcontractor Networks Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractors The typical relationship between a manufacturer and a subcontractor involves far more asset specificity in Japan than in the West. 71

72 Keiretsu Members have strong institutional linkages. Links are further strengthened by social affiliation and personal relationship among executives. Easy coordination and no holdups when vertical chain activities are performed by keiretsu members 72

73 Evidence on Keiretsu Recent research indicates that keiretsu are not what they were thought to be. Members have extensive business dealings outside their keiretsu. They borrow from the keiretsu banks as well as from outside banks. 73

74 Keiretsu Debt, Equity, and Trade Linkages in Japanese Keiretsu 74

75 Implicit Contracts Implicit contracts are unstated understanding between firms in a business relationship. Members of a keiretsu work with each other through implicit contracts. Longstanding relationship between firms can make them behave cooperatively towards each other without any formal contracts. 75

76 Implicit Contracts The threat of losing future business (and the future stream of profits) is enough to deter opportunistic behavior in any one period. The desire to protect one s reputation in the market place can be another mechanism that makes implicit contracts viable. 76

77 The Make-or-Buy Decision Tree 77

78 Example Gatton College Building Use the 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 78

79 Example Gatton College Building 79

80 View from South Limestone

81 View of New Campus Entry

82 Atrium View - South

83 Atrium View North

84 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 84

85 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 85

86 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? 86

87 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 87

88 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 88

89 Summary Alternatives arrangements to vertical integration include Franchising Strategic alliance or joint ventures Implicit contracts 89