0.1 This document discusses in brief the concept of vertical integration in a make-or-buy context, the market incentives firms pursue from either of the options and the problems they may face in real life.
0.2 The text is divided in four sections. After Introduction, section one presents briefly about vertical chain and vertical integration. Section two discusses about ‘buying from market’ while ‘in-house make’ scenario is examined briefly in section three followed by summary and conclusions in section four.
1. Vertical Chain and Vertical Integration
1.1 The activity flow of almost all organizations usually begins with inputs (raw materials for manufacturers units, for example) and concludes with delivery of final products/services. In case of textile, for example, flow of activities starts from Ginning and ends when stitched clothes are delivered to consumers. The key steps involved in textile production are shown in figure 1:
1.2 The activities’ flow mentioned in figure 1 is called vertical chain. A textile unit may choose to undertake all of above activities internally or it may decide to ‘make’ certain components internally while ‘buying’ rest from the market. The activities performed within the firm are referred to as vertical boundaries of the firm.
1.3 Organizations need to determine their boundaries, as to which functions they can perform internally and what needs to be outsourced. The dilemma of ‘make or buy’ exists in every organization and decision essentially depends on cost-benefit analysis.
1.4 However, determining the exact cost relating to make vs. buy is easier said than done. Basenko et al (2013, p.126) asserts that “a manager can easily get lost in the complexity of this balancing act”.
2. Market as a choice
2.1 The key incentive of buying from market is a short and long-term cost-benefit over in-house production. Williamson (1979) contends that the decision of make-or-buy primarily depends on cost economization, where economizing pertains to buy-in price as well as transaction cost. Where transaction cost does not constitute major proportion of total production cost, buying is more efficient. Also governance issues are avoided by procuring goods/services from market.
2.2 The markets are considered efficient as products manufactured maintain standardized quality at cheaper prices. Also the specialized producers are subjected to market discipline that helps them avoid inefficiencies that are inherent within a large integrated firm. However, buying entails transaction costs comprising cost of negotiating, monitoring and enforcing contracts. The major components of transaction costs include supplier identification, supplier selection, contract negotiation and relationship monitoring.
Transaction Cost Economics
2.3 Transaction Cost Economics (TCE) was conceptualized by Coase (1937), who examined as to why firms are needed if markets are so attractive and efficient. He contended that while markets are efficient, they do require other costs to interact with them. Theses ‘other’ costs are transaction costs.
2.4 While transacting with market entities, businesses attempt to protect themselves through effective contracts. These contracts attempt to include all set of tasks required to be undertaken to fulfil the exchange transaction effectively. They also include the remedies in case either party fails to fulfil its obligations. The contracts are considered ‘complete’ when they cover all future aspects including risk for contingencies. A complete contract ensures neither of party influences to exploit other’s weakness. Also the performance measures are defined in the contract to ensure right goods/services delivery.
2.5 However, not all the contingencies can be anticipated and covered even in a well-thought professionally-written contract. There are always certain ambiguities that cannot be predicted; hence almost all contracts lack completeness and may