Vertical Boundaries Flashcards
Make-or-Buy
• “Outsourcing is not a new topic. Often called the ‘‘make-or-buy’’ decision, organizations have been grappling with what to perform internally versus what to ‘‘buy’’ in the marketplace as long as business has existed.”
Ellram et al (2008) p.149
Vertical boundaries
determine which tasks are performed inside the firm and which to be out-sourced.
Make or Buy decision
§ an act of choosing between manufacturing a product in-house or purchasing it from an external supplier
§ Also referred to as an outsourcing decision,
§ a make-or-buy decision compares the costs and benefits associated with producing a necessary good or service internally to the costs and benefits involved in hiring an outside supplier for the resources in question.
§ To compare costs accurately, a company must considerall aspects regarding the acquisition and storage of the items must.
Processing and Handling
Raw Inputs: (tweets, iron, cows)
Transportation and Warehousing
Intermediate Goods Preprocessors (lumber mills, metalworking shops, tanneries)
Transportation and Warehousing
Assemblers (furniture “manufacturers”
Transportation and Warehousing
Retailers (furniture Stores)
Support Services
Accounting Finance Human Resource Management Legal Support Marketing Planning Other Support Services
Benefits and Costs of Using the Market
Benefits
- market firms can achieve economies of scale that in-house production can’t
- corporate success may hide the inefficient and lack on innovativeness of in-house departments
○ Value of market discipline
§ Accurate- lead to efficient solutions
Costs
- coordination of production flows through the vertical chain may be compromised when activity is purchased from an independent market
- private information may be leaked when activity is performed by an independent market firm
- Transaction costs with independent markets firms that can be avoided by performing in-house
Continuum of possibilities:
• Arms length transactions • Long term contracts Strategic alliances and joint ventures • Parent/subsidiary relationship • Activity performed internally
• Arms length transactions
○ Focal firm relationship with suppliers
○ a business deal in which buyers and sellers act independently without one party influencing the other
• Long term contracts
○ arrangements where parties prespecify a non. linear (transfer) pricing schedule before investment in specific assets.
Strategic alliances
an arrangement between two companies to undertake a mutually beneficial project while each retains its independence.
less complex and less binding
Joint venture
in which two businesses pool resources to create a separatebusinessentity
• Parent/subsidiary relationship
○ asubsidiaryis acompanythat belongs to anothercompany, which is usually referred to as theparent companyor the holdingcompany.
○ Theparentholds a controlling interest in thesubsidiary company,meaningit has or controls more than half of its stock
Activity performed internally
○ activity performedwithin the same business, using the company’s assets and employees toperformthe necessary outsourcing involves hiring outside assistance,
§ often through another business, toperformthoseactivitiesinstead of usinginternalassets or employees.
upstream
Early steps in the production process are
downstream
later steps in the production process are downstream
Forward integration
a business strategy that involves a form ofvertical integrationwhereby business activities are expanded to include control of the direct distribution or supply of a company’s products.
○ This type ofvertical integrationis conducted by a company advancing along the supply chain
Backward integration
a form ofvertical integrationin which a company expands its role to fulfil tasks formerly completed by businesses up the supply chain.
Defining Boundaries
irms need to define their vertical boundaries.
• Outside specialists who can perform vertical chain tasks are market firms.
• Market firms are often recognized leaders in their field
○ Example: UPS (delivery/logistics)
Make or Buy Fallacies
Firm should make rather than buy assets that provide competitive advantages
Outsource an activity that reduces the cost of that activity
• Making instead of buying captures the profit margin of the market firms
• Vertical integration insures against the risk of high input prices
• Making ties up the distribution channel and denies access to the rivals
• Firm should make rather than buy assets that provide competitive advantages
○ If its an asset that delivers competitive advantage, then it is not just for the sale on the market anyway as everyone would have the competitive advantage
○ An asset that is easily obtained from the market cannot be a source of advantage, whether the firm makes it or buys it.
○ If it is cheaper to obtain an asset from the market than to produce it internally, the firm should do the former.
Outsource an activity that reduces the cost of that activity
○ stems from the mistaken belief that the correct make-or-buy decision can eliminate steps from the vertical chain, is also easy to reject.
○ Consider an activity on the vertical chain, say, the distribution of finished goods from a manufacturer to retailers.
○ Choosing to buy, rather than make, does not eliminate the expenses of the associated activity. Either way, someone has to purchase the trucks and hire the drivers
• Making instead of buying captures the profit margin of the market firms
○ the firm will pay the cost.
○ Once again, if the firm can perform the activity at a lower cost than it takes to buy it from the market, it should do so.
But firms often take a look at market prices and the apparent profitability of market firms and fool themselves into thinking they can make at a lower cost
Flaws:
- the difference betweenaccounting profitandeconomic profitdiscussed in the Economics Primer.
- Because economic profit speaks to the relative profitability of different investment decisions, it is more useful than accounting profit when making business decisions.
- Even if an upstream supplier is making accounting profits, this does not imply that it is making economic profits or that a downstream manufacturing firm could increase its own economic profits by internalizing the activity.
Accounting profit
the simple difference between revenues and expenses.
Economic profit
represents the difference between the accounting profits from a given activity and the accounting profits from investing the same resources in the most lucrative alternative activity.
Strategic Balancing of Costs and Efficiency
○ Different types:
§ Technical efficiency:
□ Production Costs
§ Agency Efficiency): □ Agency Costs □ Influence Costs □ Contracting Costs □ Transactions Costs
