Make, buy or outsource?

DOUGLAS MACBETH: Make or Buy: Boundary of the firm: Why do we have firms or companies? This was a question first asked by the economist Coase in 1937. Part of the answer was that operating in the marketplace– i.e., the buy option– incurs costs because of uncertainties or the need to build protection against adversarial behaviour. And if these transaction costs are too big, it is better not to buy but to internalise the activity through vertical integration, and make or do it yourself in-house. Williamson later also won the Nobel Prize for his continuing work in this area. At the time they were working, the choice was only between make or buy, inside or outside.

But now we recognise a middle ground where we do not own the other party, but we try and behave as if we are part of the same enterprise.

Outsourcing: Outsourcing is the buy option, effectively. The logic of outsourcing is one of specialisation. We cannot be expert in everything, and so we should concentrate on and invest in what we are good at and what provides competitive advantage, and go to the market– i.e., outsource– for everything else. However, these decisions can change as economic circumstances change, so we can be pushing an activity outside and later try to bring it back. And if this is across a geographical boundary, it can be called offshoring and reshoring.

Asset specificity and lock-in: One of the important features of transaction cost economics, as it came to be called, was the concept of asset specificity. In this, an asset– equipment or even business understanding– becomes specific to one trading partner with no opportunity to use it with another. So a supplier might invest in specialised equipment that only one customer wants. So to earn from that investment, the supplier is locked in to that customer, but then the customer is also locked in to that supplier since no one else has the equipment.

Lock-in is good in that no new market search costs are needed, but is restrictive in that if the choice of partner is wrong in some way, the cost to switch to another will be significant. Sometimes switching will be needed if a new technology becomes a requirement. And then the process of exiting and switching needs to be carefully managed and, ideally, would have been built in to the contract agreement.

Risk: Risk is hugely important, and supply chains and contracts should recognise these issues. Some supplies will be highly critical and need great care and attention. But the failure of even a small contract can have ripple effects much larger than might have been anticipated. When activities are outsourced, the risk cannot be since the client is always responsible to their downstream customer, regardless of whose fault the failure was. For critical supplies, close-working relationships are needed, and the aim is to design an alignment of interests with no unpleasant surprises, and mutual support towards a common and agreed destiny. Safety resources are often needed to protect against disruptive events. But then the decision is where and who pays.

Reaction time to events is also important to day-to-day visibility, and communication can allow for mitigation and recovery before disasters happen. High levels of co-operation across a number of players are usually required.

Intellectual property: All organisations have information that is important to their business in the future. This is called intellectual property, and is worth protecting. As in many cases, it is the main asset on which they trade. It can be tempting for unscrupulous others to obtain it if they can without paying for it or spending their own money and effort to create an equivalent. So the legal protection of IP is a requirement, but there also has to be a functioning legal process to protect and address breaches of fair processes. In any outsourcing contract, the potential is that IP is transferred to be used by the supplier, but in so doing, the customer loses control and might create their own competitor.

This is especially the case in agreements usually with foreign governments for large value contracts where there is imposed an offset obligation. This is where some of the money spent by the customer is required to be recycled or offset back to the country of origin to be spent there. The suppliers do not want to create a local competitor and will do their best not to transfer critical IP as part of this process. Where there has been great expansion of the outsourcing and offshoring option around the globe, there are signs that some of this flow is being reversed. The inventory in the global pipeline costs a lot of money to secure, and might be interrupted by disaster or piracy.

And distance can equate to time to change so that for a very responsive business, it can be difficult to source this efficiently from the other side of the world. If the reason to outsource was low labour cost, this is often only a temporary benefit as the local people become more skilled and demanding. In all such outsourcing, the transfer of skills to make the product or service at the required quality levels can sometimes require more training and supervision than initially budgeted for. And so the real cost of acquisition is more than the manufactured cost in the cheap labour country. Another factor which must come into play are the costs of shipping items around the globe in terms of carbon pollution.

While the dirty fuel used in ships’ engines has been changed, it is still a factor in health and climate concerns, and at least one scenario is that the distances involved might reduce such that supplier and customer markets might be in more limited local groupings, like the European Union or ASEAN regions.