Integral Logistics Management — Operations Management and Supply Chain Management Within and Across Companies

2.1.1 The Make-or-Buy Decision — Transaction Costs as the Reason of Insourcing or Outsourcing

Intended learning outcomes: Produce an overview on outsourcing and transaction costs. Disclose some factors that lead to a buy, or to a make decision. Differentiate between various forms of company-internal organization.

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A make-or-buy decision is the choice between outsourcing and insourcing.

According to [ASCM22], insourcing  is using the firm’s internal resources to provide goods and services, and outsourcing is the process of having suppliers provide goods and services that were previously provided internally.

When does a company redimension itself through outsourcing? With a view to the entre­preneurial objectives in section 1.3.1, this always occurs when a product or part of it can be produced in a qualitatively better, cheaper, faster, more reliable and more flexible way than within the company's own organization by procuring it from third parties.

A make-or-buy cost analysis is, according to [ASCM22], a comparison of all the costs associated with making an item versus the cost of buying the item.

In the following, we will assume that the same quality product may be procured on the market as could be produced by the company itself. The crucial factor in forming a company under this condition is transaction costs, according to Nobel Prize winner Ronald H. Coase ([Coas93]; this fundamental work was actually written in 1937). For the transaction-costs approach, see also [Pico82].

The transaction process is the transmission of goods from vendor (that is, a seller of a good in the marketplace) to buyer.
Transaction costs, or market transaction costs of goods, are the costs of the organization as a production factor. These include all costs of the transaction process that are not set in price by the market.

Transaction costs thus arise when price does not reflect all the necessary information on goods; for example, due to inability, opportunism, uncertainty, or market distortions. Transaction costs are thus the cost of information and include the following types of costs:

  • Search and initiation costs: These are, for example, the costs of locating and obtaining information on potential business partners and the conditions involved.
  • Negotiation costs include the actual costs of negotiation and decision making, legal counsel, and fees.
  • Control costs include expenditures necessary to coordinate orders so as to maintain quality, quantity, costs, and delivery dates as well as eventual costs to adapt to changes in orders. In addition, there are costs to ensure other contractual agreements, in particular patent protection, licensing and security agreements, and so on.

Transaction costs can be compared with friction losses in the relations in a Supply chain. See in addition also [Port04a] and [Port04b]. Figure 2.1.1.1 lists five factors influencing a make-or-buy decision, each with examples which speak for a buy decision, (or outsourcing) or for a make decision, (or insourcing).

Factor of influence-->Buy-Decision / Outsourcing--> Make-Decision / Insourcing
Specificity of product and processes or locationProduct and process are not specific. For development and production, there are already several suppliers on the market who have specialists and specific infrastructure. Transports are also not a problem.Specific investments in the production infrastructure and qualification of the employees as well as the necessary geographical proximity of the supplier increase the transaction costs. The specificity of the products allows better product differentiation.
Complexity of product and processes, and time-to-productProjects are too complex or too large to be completed quickly enough with the capabilities and capacity of the company's own staff.Order coordination and control become more complex and difficult. The risk of opportunistic behavior on the part of the supplier increases.
Core competencies, greater degree of innovation in product and process, and time to market (time to product innovation)New products require technologies that the company does not master. New technologies must be converted into marketable products in an ever shorter time. For certain competen­cies, sourcing from third parties seems uncritical. One wants access to the know-how of another company.A lead in know-how and innovative strength through core competencies are decisive for the survival of the company. High process know-how allows short lead times and flexibility. The use of third parties means too great a risk and entails high control costs.
Capital requirements and cost breakdown structureThe capital required to build up / retain know-how is not affordable. Specialists do not fit into the wage structure and culture or cannot be fully utilized. The same applies to the infrastructure.The company has a favorable size and structure, so that in-house development and production brings advantages. The capital requirements are manageable.
Lack of trust and lack of stabilityIn the affected area, the company depends on too few people. It cannot develop a sustainable culture of its own. Nor can it remedy the situation by, for example, forming an alliance with several like-minded companies.There are doubts that a supplier's relationships with key people, quality and customer focus will remain good, and that it will pass on its process improvements to a sufficient extent via a lower price.

Fig. 2.1.1.1         Factors influencing a make-or-buy decision.

In addition, outsourcing can be forced in the case of a countertrade: If a company wants to gain a corporation as a customer, it can be forced in return to accept a subsidiary of the corporation as a supplier for components that it could also manufacture itself. The same applies in the case of a state as a customer and companies based in that state.

Thorough evaluation of all factors thus helps the firm to determine the optimum depth of added value of the company.

  • Vertical integration is the degree to which a firm has decided to directly produce multiple value-adding stages from raw material to the sale of the product to the end user ([ASCM22]).
  • Backward/ forward integration is the process of buying or owning elements of the production cycle and the channel of distribution, backward toward raw material suppliers  / forward toward the final consumer (cf. [ASCM22]).

Clearly, there are also friction losses within a company.

Internal transaction costs are all costs related to the processing of com­pany-internal transactions that would not arise if one single individual could do the pro­cessing.

Internal transaction costs include the costs of building up and coordinating personnel on an ongoing basis, management and control costs, flexibility costs, and throughput time costs. Attention is therefore paid to the human factor. See also [Ulic11]. A suitable organization of the internal supply chain can decisively support the cooperation within a company:

  • A profit center in its pure form plans and acts like an independent sub-firm. It bears comprehensive responsibility. It also has the authority to accept or reject orders from other organizational units of the company. In the impure form, the head office does not assign the necessary competences to the profit center. For example, such a "centralist kingdom" transfers cost and revenue responsibility to a subsidiary but reserves the right to decide from whom it may purchase and to whom it may deliver.
  • A cost center in its pure form receives orders for products with quantities and due dates from a central office, which it must meet together with quality specifications. However, it bears no responsibility for this, since it manages neither its own resources (e.g. personnel, production infrastructure) nor purchased resources (e.g. raw materials, semi-finished products). In its impure form, a cost center autono­mously determines order due dates, for example, without considering the interests of the entire supply chain. Such "kingdoms in departments" can also arise if a cost center is measured against isolated targets, such as its capacity utilization.
  • A semi-autonomous organizational unit is integrated into a company strategy. E.g. it must accept orders from a head office or other units of the company, or obtain certain components from them. In contrast, it is autonomous in its order ma­na­ge­ment. It negotiates due dates, type and quantity of goods with its customers and suppliers and processes the orders on its own. Within the framework conditions set at the strategic level of the company, there is freedom of action. Depending on this, a semi-autonomous organizational unit behaves more like a profit or a cost center.

Quiz on Chapter 2.1.1. Not yet available

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Course section 2.1: Subsections and their intended learning outcomes

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