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Lecture 4The Vertical Boundaries of the Firm:

Make vs. Buy

Overview

Make vs. Buy– Upstream, downstream– Defining boundaries– Some make-or-buy fallacies

Reasons to buyReasons to “make”Summarizing make or buy decision

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Vertical Boundaries: The Vertical Chain of Aluminum Production

Bauxite ore

Alumina

Molten aluminum

Ingots

Plate Sheet Foil Wire Rod Bar

Final goods (examples)

Transportation, Building and Construction, Machinery, Containers and Packing, Etc.

Refining

Smelting

Casting / Alloying

Initial fabrication

Further fabrication

Recycling

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!

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

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. http://aluminiuminsider.com/alcoas-split-a-smart-move-2/

Vertical Boundaries: The Vertical Chain of Aluminum Production

Bauxite ore

Alumina

Molten aluminum

Ingots

Plate Sheet Foil Wire Rod Bar

Final goods (examples)

Transportation, Building and Construction, Machinery, Containers and Packing, Etc.

Refining

Smelting

Casting / Alloying

Initial fabrication

Further fabrication

Recycling

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:

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What Does “Make or Buy” Mean?

In addition to materials, this process also includes support services such as finance, marketing and salesOrganization of “vertical chain” is

important part of business strategy

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“Make or Buy” Explained Further

Firms use intermediate products and services in their production processWhich 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

Make-or-Buy Continuum

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Arm’s length markettransactions

Long-term contracts

Strategic alliances and joint ventures

Parent / subsidiary relationships

Performactivity internally

Lessintegrated

More integrated

Buy Make

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Examples

Examples of firms that “make”– Honda– Exxon Mobil

Examples of firms that “buy”– Toyota– Adidas, Nike– Apple

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: http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Trains in Vain_ Epic CSX Traffic Jam Snarls Deliveries, From Co.pdf

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Make versus Buy Considerations

Decision depends on costs and benefits of eachNeed to consider ALL benefits and costsThink about opportunity costsIntermediate solutions are possible

– Strategic alliances with vendors– Joint ventures– Franchises

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More Make versus Buy ConsiderationsEconomies of scale achieved by firm

versus “market”Value of market disciplineEase of co-ordination of production flows

in-houseTransaction costs when dealing with

“market”

Make or Buy Fallacies

Firms should make an asset, rather than buy it, if the asset is the source of competitive advantageFirms should buy, rather than make, to

avoid the cost of making the productFirms should make rather than buy to

avoid paying a profit margin to an independent firm

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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

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Reasons to Buy

Patents/proprietary information other unique situations that makes low-cost production possibleEconomies of scale unavailable to in-

house unitsMarket discipline versus ability of in-house

units to hide their inefficiencies behind overall corporate success– Book calls these agency and influence costs

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 tyresannually.

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.

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Toyota’s acquisition of tires

Quantity of tires

Aver

age

cost C

*

C’

MES10m

LRAC

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Economies of Scale Again

Consider IMG Tennis Academy run by Nick Bollettieri in Bradenton, FLThey “produce” tennis playersThey can make tennis balls or buy them

from “the market”

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IMG Tennis Academy

Quantity of tennis balls

Aver

age

cost

C*

C’

Q*Q’

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IMG Tennis Academy (Continued)

Suppose the Academy only uses Q’ tennis ballsThey 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’)

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Economies of Scale (Continued)

IMG Tennis Academy could make Q* tennis balls, but competing tennis academies would rather buy from independent seller than competitorAn 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

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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

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Economies of Scale (Continued)

Insurance provides another example of make or buy and economies of scaleFirms 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

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 firmOthers 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 connections29

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Agency Costs

The incentives to be efficient and innovative are weaker when a task is performed in-houseAgency costs are particularly problematic

if the task is performed by a “cost center” within an organizationIt is difficult to internally replicate the

incentives faced by market firms

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Influence Costs

In addition to agency costs, performing a task in-house will lead to “influence costs” as well“Internal Capital Markets” allocate scarce

capitalAllocations can be favorably affected by

influence activitiesResources consumed by influence

activities represent “influence costs”

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? http://www.cnn.com/2012/07/26/travel/tire-recall/index.html https://www.wsws.org/en/articles/2011/12/coop-d14.html http://www.truckinginfo.com/article/story/2013/05/the-high-cost-of-

tires.aspx 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?

Advantages of using the market: Providing Discipline

Can be true even when we are talking about making a shirt: http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Penny's Shirts WSJ 11-09-03.pdf

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Reasons to Make

Production efficienciesCosts imposed by poor coordinationReluctance of partners to develop and share

valuable private informationTransactions costs that can be avoided by

performing the task in-houseReputation externalitiesEach problem can be traced to difficulties in

contracting

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? https://www.lightmetalage.com/news/industry-news/casthouse/service-center-metals-expanding-two-new-aluminum-casting-lines/

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Contracts

Firms often use contracts when certain tasks are performed outside the firmA “complete” contract protects each party

to a transaction from opportunistic behavior of other(s)Most “real-life” contracts are incomplete

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Reasons for Incomplete Contracts

Bounded rationality– Individuals cannot foresee all possible

contingenciesDifficulties in specifying/measuring

performance– Hard to define “normal wear and tear”

Asymmetric information– One party can misrepresent information with

impunity

Contract Law

Established contract law helps facilitate transactions– Traditions established by the court regarding

who is responsible for whatIn 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

Contract Law

Still remains vague and open to different interpretations resulting in litigationLitigation is costly and can hurt or break a

relationship

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Coordination Problems

For successful coordination one party needs to make decisions that depend on the decision made by othersA good fit should be accomplished in

several dimensions, such as: – Timing– Size– Color– Sequence

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Coordination Problems (Continued)

Without good coordination, bottlenecks arise in the production processCoordination is especially important when

“design attributes” are presentTo ensure coordination, firms rely on

contracts that specify delivery dates, design tolerances and other performance targets

Reasons for vertical integration: extensive coordinationChicken 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 1967. 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): 116–129]

Vertical connection between growers and processors: long-term contracts http://millerpoultry.com/potential-grower-information/

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. http://smallbusiness.chron.com/vertical-integration-beef-industry-14614.html

https://www.youtube.com/watch?v=LWxjY-yDAn8

Reasons for vertical integration: extensive coordination

What about making an airplane? http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Boeing Dreamliner Production WSJ 02-07-09.pdfComputers and Software?

http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Companies Vertical WSJ 30-11-09.pdf

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More on Design Attributes

Design attributes are attributes that need to relate to each other preciselySmall errors in design attributes are

extremely costlyIf coordination is critical, administration

control may replace the market mechanismDesign attributes may be moved in-house

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. https://www.youtube.com/watch?v=mYWWregndoY

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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

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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 informationIn practice noncompete clauses can be

hard to enforce

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 free-riding on the reputation established by everyone else in the chain.

Solutions? Vertical integration? Franchising?

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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 costsOutsourcing entail costs of negotiating,

writing and enforcing contracts

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Transactions Costs (Continued)

Costs are incurred due to opportunistic behavior of parties to the contract and efforts to prevent such behaviorTransactions costs explain why economic

activities occur outside the price systemSources of transactions costs

– Investments in relationship-specific assets– Rents and quasi-rents– Holdup problem

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.

Types of asset specificity

Site specificity: mine-mouth power plant http://trib.com/business/energy/mine-mouth-coal-power-plants-a-trade-off-between-distribution/article_83f38a42-51ab-51ce-9e11-9de4183a5a07.html

Physical asset specificity: the doughnut machine https://www.youtube.com/watch?v=Qu0ISv_GeHI

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? http://gatton.uky.edu/programs/mba/one-year-accelerated-mba http://www.uky.edu/hr/training/offerings/uk-business-procedures-certification-series

Dedicated assets: Hopple Plastics and Boston Market plates;TVA, Peabody Coal Co., and “Big Hog” http://www.rockportky.com/CoalMines/SinclairMine/SinclairMine.html For the musical version of the story: https://www.youtube.com/watch?v=DEy6EuZp9IY

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Rent and Quasi-rent

The term “rent” denotes economic profits –profits after all the economic costs, including the cost of capital, are deductedQuasi-rent is the excess economic profit

from a transaction compared with economic profits available from an alternate transaction

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Rent and Quasi-rent Example

Baa Goat Farm has agreed to sell goat milk to Feta Feta Cheese and receive revenue of R1

Baa incurs total variable costs of C to produce the milkFeta Feta also requires Baa to process the

milk using a special piece of equipment that rents for I.

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Rent and Quasi-rent Example

If Baa Goat Farm sells milk to Feta FetaCheese they earn an economic profit of π1 = R1 - 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 R2 and their economic profit will be π2 = R2 - C

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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 (π1)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 (π1- π2)

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The Holdup Problem

Whenever π1 > π2, Feta Feta can benefit by holding up Baa Goat and capturing the quasi-rent for itselfA complete contract will not permit the

breachWith incomplete contracts and

relationship-specific assets, quasi-rent may exist and lead to the holdup problem

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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

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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

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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. http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Amazon Disney WSJ 11-08-14.pdf

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Holdup and Underinvestment

When there is a holdup, the investment made in relationship-specific assets loses valueAnticipating holdups, firms will make

otherwise sub-optimal level of investments and suffer higher production costs

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Asset Specificity and Transactions Costs – SummaryRelationship-specific assets support a

particular transactionRedeploying to other uses is costlyQuasi-rents become available to one party

and there is incentive for a holdupPotential for holdups lead to

– Underinvestment in these assets– Investment in safeguards– Reduced trust

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.

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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.

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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

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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

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Strategic Alliances Can Be Difficult

“Ericsson Joint Venture Looks Like Sony's Show,” WSJ, 4/26/01. http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Ericsson Sony Joint Venture WSJ 4-26-01.pdf

“Sony Buys Ericsson Stake in Handset Joint Venture,” WSJ, 10/28/11. http://gattonweb.uky.edu/faculty/troske/teaching/eco411/articles/Sony Buys Ericsson WSJ 10-28-11.pdf

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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.

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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)

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Subcontractor Networks

Japanese manufacturers maintain close, informal, long term relationship with their network of subcontractorsThe typical relationship between a

manufacturer and a subcontractor involves far more asset specificity in Japan than in the West.

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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

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Evidence on Keiretsu

Recent research indicates that keiretsuare 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.

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Debt, Equity, and Trade Linkages in Japanese

Keiretsu

Keiretsu

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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.

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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.

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The Make-or-Buy Decision Tree

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Example—Gatton College Building

Use the renovation and expansion of the Gatton College building on UK campus to illustrate some of these issuesRenovating and expanding our existing

buildingTotal cost $65M entirely privately financed

(no money from the state of Kentucky)We are buying this work not making it

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Example—Gatton College Building

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View from South Limestone

View of New Campus Entry

Atrium View - South

Atrium View – North

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

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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

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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?

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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 usersA fundamental question is which parts of

the chain of production a firm should perform itself and which parts it should purchase from the market

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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

Summary

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

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