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 Basis of Forming Companies

Intended learning outcomes: Produce an overview on outsourcing, insourcing, and various kinds of transaction costs. Disclose some factors that lead to a buy decision or to a make decision. Describe counterdeals and protectionism. Differentiate between various forms of company-internal organization, and identify the internal transaction costs typically linked with such forms.



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

In outsourcing, parts of the value-added chain are turned over to other companies. Insourcing refers to the formation or expansion of companies by means of taking parts of the value-added chain into the company.

In what cases will an organization disband or become re-dimensioned by means of outsourcing? Keeping in mind the objectives of the enterprise outlined in Section 1.3.1, a company will choose outsourcing whenever a product or product part can be produced on the whole in better quality and more cheaply, rapidly, reliably, and flexibly by a third party than when produced in-house. If the contrary is the case, the decision is made to form or expand a company through insourcing.

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 are comparable to friction loss in the relations in a supply chain, influenced by factors of the “speci­ficity” and “risk” (uncertainty) type (see here also [Port04a] and [Port04b]). For each factor the following list contains examples that lead to a buy decision, or outsourcing, as well as examples that speak well for a make decision, or insourcing.

The specificity of product and processes or location makes a first factor:

  • Outsourcing: Product and process are not specific. For design and manufacturing, there are a number of bidders on the market. Those companies already have specialists and specific infra­structures at their disposal. Moreover, transport is not a problem.
  • Insourcing: Trans­action costs rise, whenever specific investitures in production infra­struc­ture and the qualification of employees are required, or the supplier needs to be in a proximate location. On the other hand, product specificity creates better product diffe­ren­tia­tion and thus the building up of a trade name and market share.

Complexity of product and processes, and time-to-product make a second factor:

  • Outsourcing: The projects are too complex or too extensive to be realized on time by the company with the capabilities and capacities of its personnel. Small enterprises often face this prob­lem, for customer-order-specific tasks in the value-added process.
  • Insourcing: Order coordination and control become more costly and more difficult. The danger of opportunistic behavior on the part of the supplier increases.

Core competenciesgreater degree of innovation in product and process, and time to market (time to product innovation) make a third factor:

  • Outsourcing: Superior quality products require technology that is more difficult to command. Within increasingly shorter time periods, new technologies have to produce goods that succeed on the market. Procuring some of the company’s competencies from a third party does not cause any critical problems, even if know-how that exists may be lost. In addition, the company desires access to the know-how of another organization.
  • Insourcing: A lead in know-how through the development of core competencies and the achievement of innovation secure the survival of the company. A great store of know-how results in short lead times and flexibility. Continuing to give work to third parties involves too great a risk and high control costs.

Capital requirements and cost breakdown structure make a forth factor:

  • Outsourcing: The company cannot afford the cash require­ments for amassing and maintaining company know-how. Specialists do not fit into the payroll or the company culture. The firm cannot fully utilize their specific abilities. The same holds for the infrastructure.
  • Insourcing: The company’s favorable size and structure permit the advantages of in-house design and manufacturing. The cash requirements are affordable.

Lack of trust and lack of stability make a fifth factor:

  • Outsourcing: The company is dependent on too few or even individual persons. It cannot build up a culture of suffi­cient capacity in the respective area. Remedial action, such as co­operating with several like-minded companies, is not possible.
  • Insourcing: Insufficient information or frequent changes in partner relationships within a supply chain lead to an increase in transaction costs. Are the relationships to the crucial individuals stable? Is quality main­tained at a certain level? Does the supplier retain custo­mer focus and user orientation? Do the supplier’s prices reflect a learning curve (that is, the supplier’s rate of improve­ment due to the frequently repeated transaction) and decrease?

In addition, outsourcing can be forced in the following contexts:

  • CounterdealsWith their various subsidiary companies, corporati­ons can be both potential customers and suppliers of a manufactu­rer. If a company wishes to gain them as customers, it may have to agree to a counterdeal stipulating that one of their subsidiaries will supply certain components, even if it could produce these itself.
  • ProtectionismCertain markets elude the laws of a free economy. Political decisions can force manufacturers — in order to gain market access — to form “joint ventures” with companies in other countries. This type of cooperation then involves parts of the supply chain that manufacturers could actually process themselves.

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 ([APIC16]).
  • 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. [APIC16]).

Clearly, there are also friction losses within a company.

Internal transaction costs are all costs related to the processing of com­pany-internal transactions among the organizational units involved. These are all costs that would not arise if one single individual could do the pro­cessing. Internal transaction costs arise from a lack of mutual information due to, e.g., inability, opportunism, uncertainty, or diverging interests.

Internal transaction costs are thus the price of information.[note 201] They include types of costs that are similar to market transac­tion costs. These are the costs of shaping an organization, the ongoing coordination of workers, planning and control costs, and flexibility costs, as well as costs of lead times.

The right form of organization can be decisive in supporting company-internal cooperation, especially when the facility locations are at a great distance from one another or handle different product families or services. Various forms of organization are possible:

  • Profit center within a decentralized or product-focused organiza­tion: In its pure form, a profit center plans and acts just like an independent subcompany. It carries comprehensive responsibility and also has the authority to accept or reject orders from other organizational units of the company.
  • Cost center within a centralized or process-focused organization: In its pure form, a cost center receives clearly formulated orders: due date, type, and quality of products. The often complex and capital-inten­sive processes are triggered by order management of a central department. The cost center then has the task of fulfilling quality and quantity requirements, and due dates; it does not, however, carry responsibility for these, as it does not have its own resources (personnel and production infra­structure) nor does it manage resources procured from the outside (for example, information, semifinished goods, and raw materials).
  • A semiautonomous organizational unit is linked to a company-wide strategy. For example, it must accept orders or must procure certain components from other organizational units of the company or from a central department. However, it is autonomous with regard to order processing and fulfillment. It negotiates due dates, type, and quantity of goods with customers and suppliers and realizes order processing under its own direction. At the level of company strate­gies, framework conditions are set within which the unit has some degrees of freedom. In dependency upon framework conditions, semi-autonomous orga­nizational units may act as profit centers or cost centers. For this reason, they are seldom stable in the long term.

Internal transaction costs are particularly dependent on the persons involved. Here the human factor has to be closely attended to. The reader is referred to [Ulic11]. Two com­mon mistakes result when all-too-human characteristics find expression:

  • “Kingdoms” within departments or foreman areas: Decentralized organizational units take on authority without perceiving the con­jugate, necessary responsibility. For example, they might set order due dates autonomously without taking the superordinate interests of the total supply chain into consideration. “Kingdoms” such as these also arise when decentralized organizational units are evalua­ted on the basis of isolated objectives, such as capacity utilization.
  • Centralistic kingdoms: Central management delegates responsi­bility to decentralized organizational units without giving them the necessary authority. Holding companies, for example, may turn over cost and profit responsibility to subsidiaries and affiliated companies while maintaining the right to choose these companies’ suppliers and customers.

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Course section 2.1: Subsections and their intended learning outcomes