Chapter 16 Outline

Make-or-Buy Decisions

International businesses frequently face sourcing decisions, decisions about whether they should make or buy the component parts that go into their final product. Should the firm vertically integrate to manufacture its own component parts or should it outsource them, or buy them from independent suppliers? Make-or-buy decisions are important factors of many firms' manufacturing strategies. In the automobile industry, for example, the typical car contains more than 10,000 components, so automobile firms constantly face make-or-buy decisions. Ford of Europe, for example, produces only about 45 percent of the value of the Fiesta in its own plants. The remaining 55 percent, mainly accounted for by component parts, come from independent suppliers. In the athletic shoe industry, the make-or-buy issue has been taken to an extreme with companies such as Nike and Reebok having no involvement in manufacturing; all production has been outsourced, primarily to manufacturers based in low-wage countries.

Make-or-buy decisions pose plenty of problems for purely domestic businesses but even more problems for international businesses. These decisions in the international arena are complicated by the volatility of countries' political economies, exchange rate movements, changes in relative factor costs, and the like. In this section, we examine the arguments for making components and for buying them, and we consider the trade - offs involved in these decisions. Then we discuss strategic alliances as an alternative to manufacturing component parts within the company.

The Advantages of Make

The arguments that support making component parts in-house--vertical integration--are fourfold. Vertical integration may be associated with lower costs, facilitate investments in highly specialized assets, protect proprietary product technology, and facilitate the scheduling of adjacent processes.

Lower Costs

It may pay a firm to continue manufacturing a product or component part in-house if the firm is more efficient at that production activity than any other enterprise. Boeing, for example, recently undertook a very detailed review of its make-or-buy decisions with regard to commercial jet aircraft (for details see the accompanying Management Focus). It decided that although it would outsource the production of some component parts, it would keep the production of aircraft wings in-house. Its rationale was that Boeing has a core competence in the production of wings, and it is more efficient at this activity than any other comparable enterprise in the world. Therefore, it makes little sense for Boeing to out-source this particular activity.

Facilitating Specialized Investments

We first encountered the concept of specialized assets in Chapter 6 when we looked at the economic theory of vertical foreign direct investment. A variation of that concept explains why firms might want to make their own components rather than buy them.¹⁵ The argument is that when one firm must invest in specialized assets to supply another, mutual dependency is created. In such circumstances, each party fears the other will abuse the relationship by seeking more favorable terms.

Imagine Ford of Europe has developed a new, high - performance, high - quality, and uniquely designed carburetor. The carburetor's increased fuel efficiency will help sell Ford cars. Ford must decide whether to make the carburetor in-house or to contract out the manufacturing to an independent supplier. Manufacturing these uniquely designed carburetors requires investments in equipment that can be used only for this purpose; it cannot be used to make carburetors for any other auto firm. Thus, investment in this equipment constitutes an investment in specialized assets.

Let us first examine this situation from the perspective of an independent supplier who has been asked by Ford to make this investment. The supplier might reason that once it has made the investment, it will become dependent on Ford for business since Ford is the only possible customer for the output of this equipment. The supplier perceives this as putting Ford in a strong bargaining position and worries that once the specialized investment has been made, Ford might use this to squeeze down prices for the carburetors. Given this risk, the supplier declines to make the investment in specialized equipment.

Now take the position of Ford. Ford might reason that if it contracts out production of these carburetors to an independent supplier, it might become too dependent on that supplier for a vital input. Because specialized equipment is required to produce the carburetors, Ford cannot easily switch its orders to other suppliers who lack that equipment. (It would face high switching costs.) Ford perceives this as increasing the bargaining power of the supplier and worries that the supplier might use its bargaining strength to demand higher prices.

Thus, the mutual dependency that outsourcing would create makes Ford nervous and scares away potential suppliers. The problem here is lack of trust. Neither party completely trusts the other to play fair. Consequently, Ford might reason that the only safe way to get the new carburetors is to manufacture them itself. It may be unable to persuade any independent supplier to manufacture them. Thus, Ford decides to make rather than buy.

In general, we can predict that when substantial investments in specialized assets are required to manufacture a component, the firm will prefer to make the component internally rather than contract it out to a supplier. A growing amount of empirical evidence supports this prediction.¹⁶

Proprietary Product Technology Protection

Proprietary product technology is technology unique to a firm. If it enables the firm to produce a product containing superior features, proprietary technology can give the firm a competitive advantage. The firm would not want this technology to fall into the hands of competitors. If the firm contracts out the manufacture of components containing proprietary technology, it runs the risk that those suppliers will expropriate the technology for their own use or that they will sell it to the firm's competitors. Thus, to maintain control over its technology, the firm might prefer to make such component parts in-house. An example of a firm that has made such decisions is given in the accompanying Management Focus, which looks at make-or-buy decisions at Boeing. While Boeing has decided to outsource a number of important components that go toward the production of an aircraft, it has explicitly decided not to outsource the manufacture of wings and cockpits because it believes that doing so would give away key technology to potential competitors.

Improved Scheduling

The weakest argument for vertical integration is that production cost savings result from it because it makes planning, coordination, and scheduling of adjacent processes easier.¹⁷ This is particularly important in firms with just-in-time inventory systems (which we discuss later in the chapter). In the 1920s, for example, Ford profited from tight coordination and scheduling made possible by backward vertical integration into steel foundries, iron ore shipping, and mining. Deliveries at Ford's foundries on the Great Lakes were coordinated so well that ore was turned into engine blocks within 24 hours. This substantially reduced Ford's production costs by eliminating the need to hold excessive ore inventories.

For international businesses that source worldwide, scheduling problems can be exacerbated by the time and distance between the firm and its suppliers. This is true whether the firms use their own subunits as suppliers or use independent suppliers. Ownership is not the issue here. As we see in the closing case, Timberland may achieve tight scheduling with its globally dispersed parts suppliers without vertical integration. Thus, although this argument for vertical integration is often made, it is not compelling.

The Advantages of Buy

The advantages of buying component parts from independent suppliers are that it gives the firm greater flexibility, it can help drive down the firm's cost structure, and it may help the firm to capture orders from international customers.

Strategic Flexibility

The great advantage of buying component parts from independent suppliers is that the firm can maintain its flexibility, switching orders between suppliers as circumstances dictate. This is particularly important internationally, where changes in exchange rates and trade barriers can alter the attractiveness of supply sources. One year Hong Kong might be the lowest-cost source for a particular component, and the next year, Mexico may be.

Sourcing component parts from independent suppliers can also be advantageous when the optimal location for manufacturing a product is beset by political risks. Under such circumstances, foreign direct investment to establish a component manufacturing operation in that country would expose the firm to political risks. The firm can avoid many of these risks by buying from an independent supplier in that country, thereby maintaining the flexibility to switch sourcing to another country if a war, revolution, or other political change alters that country's attractiveness as a supply source.

However, maintaining strategic flexibility has its downside. If a supplier perceives the firm will change suppliers in response to changes in exchange rates, trade barriers, or general political circumstances, that supplier might not be willing to make specialized investments in plant and equipment that would ultimately benefit the firm.

Lower Costs

Although vertical integration is often undertaken to lower costs, it may have the opposite effect. When this is the case, outsourcing may lower the firm's cost structure. Vertical integration into the manufacture of component parts increases an organization's scope, and the resulting increase in organizational complexity can raise a firm's cost structure. There are three reasons for this.

First, the greater the number of subunits in an organization, the greater are the problems of coordinating and controlling those units. Coordinating and controlling subunits requires top management to process large amounts of information about subunit activities. The greater the number of subunits, the more information top management must process and the harder it is to do well. Theoretically, when the firm becomes involved in too many activities, headquarters management will be unable to effectively control all of them, and the resulting inefficiencies will more than offset any advantages derived from vertical integration.¹⁸ This can be particularly serious in an international business, where the problem of controlling subunits is exacerbated by distance and differences in time, language, and culture.

Second, the firm that vertically integrates into component part manufacture may find that because its internal suppliers have a captive customer in the firm, they lack an incentive to reduce costs. The fact that they do not have to compete for orders with other suppliers may result in high operating costs. The managers of the supply operation may be tempted to pass on cost increases to other parts of the firm in the form of higher transfer prices, rather than looking for ways to reduce those costs.

Third, leading on from the previous point, vertically integrated firms have to determine appropriate prices for goods transferred to subunits within the firm. This is a challenge in any firm, but it is even more complex in international businesses. Different tax regimes, exchange rate movements, and headquarters' ignorance about local conditions all increase the complexity of transfer pricing decisions. This complexity enhances internal suppliers' ability to manipulate transfer prices to their advantage, passing cost increases downstream rather than looking for ways to reduce costs.

The firm that buys its components from independent suppliers can avoid all these problems and the associated costs. The firm that sources from independent suppliers has fewer subunits to control. The incentive problems that occur with internal suppliers do not arise when independent suppliers are used. Independent suppliers know they must continue to be efficient if they are to win business from the firm. Also, because independent suppliers' prices are set by market forces, the transfer pricing problem does not exist. In sum, the bureaucratic inefficiencies and resulting costs that can arise when firms vertically integrate backward and manufacture their own components are avoided by buying component parts from independent suppliers.

Offsets

Another reason for outsourcing some manufacturing to independent suppliers based in other countries is that it may help the firm capture more orders from that country. As noted in the Management Focus on Boeing, the practice of offsets is common in the commercial aerospace industry. For example, before Air India places a large order with Boeing, the Indian government might ask Boeing to push some subcontracting work toward Indian manufacturers. This kind of quid pro quo is not unusual in international business, and it affects far more than just the aerospace industry. Representatives of the US government have repeatedly urged Japanese automobile companies to purchase more component parts from US suppliers in order to partially offset the large volume of automobile exports from Japan to the United States.

Trade-offs

Trade-offs are involved in make-or-buy decisions. The benefits of manufacturing components in-house seem to be greatest when highly specialized assets are involved, when vertical integration is necessary for protecting proprietary technology, or when the firm is simply more efficient than external suppliers at performing a particular activity.

When these conditions are not present, the risk of strategic inflexibility and organizational problems suggest that it may be better to contract out component part manufacturing to independent suppliers. Since issues of strategic flexibility and organizational control loom even larger for international businesses than purely domestic ones, an international business should be particularly wary of vertical integration into component part manufacture. In addition, some outsourcing in the form of offsets may help a firm gain larger orders in the future.

Strategic Alliances with Suppliers

Several international businesses have tried to reap some of the benefits of vertical integration without the associated organizational problems by entering strategic alliances with essential suppliers. For example, in recent years we have seen an alliance between Kodak and Canon, under which Canon builds photocopiers for sale by Kodak, and an alliance between Apple and Sony, under which Sony builds laptop computers for Apple. By these alliances, Kodak and Apple have committed themselves to long-term relationships with these suppliers, which have encouraged the suppliers to undertake specialized investments. Recall from our earlier discussion that a lack of trust inhibits suppliers from making specialized investments to supply a firm with inputs. Strategic alliances build trust between the firm and its suppliers. Trust is built when a firm makes a credible commitment to continue purchasing from a supplier on reasonable terms. For example, the firm may invest money in a supplier--perhaps by taking a minority shareholding--to signal its intention to build a productive, mutually beneficial long-term relationship.

This kind of arrangement between the firm and its parts suppliers was pioneered in Japan by large auto companies such as Toyota. Many Japanese automakers have cooperative relationships with their suppliers that go back for decades. In these relationships, the auto companies and their suppliers collaborate on ways to increase value - added by, for example, implementing just-in-time inventory systems or cooperating in the design of component parts to improve quality and reduce assembly costs. These relationships have been formalized when the auto firms acquired minority shareholdings in many of their essential suppliers to symbolize their desire for long-term cooperative relationships with them. At the same time, the relationship between the firm and each essential supplier remains market mediated and terminable if the supplier fails to perform up to standard. By pursuing such a strategy, the Japanese automakers capture many of the benefits of vertical integration, particularly those arising from investments in specialized assets, without suffering the organizational problems that come with formal vertical integration. The parts suppliers also benefit from these relationships because since they grow with the firm they supply and they share in its success. Because of these strategies, Toyota manufactures only 27 percent of its component parts in-house, compared to 48 percent at Ford and 67 percent at GM. Of these three firms, Toyota appears to spend the least on component parts, suggesting it has captured many of the benefits that induced Ford and GM to vertically integrate.¹⁹

In general, the trends toward just-in-time systems (JIT), computer-aided design (CAD), and computer-aided manufacturing (CAM) seem to have increased pressures for firms to establish long-term relationships with their suppliers. JIT, CAD, and CAM systems all rely on close links between firms and their suppliers supported by substantial specialized investment in equipment and information systems hardware. To get a supplier to agree to adopt such systems, a firm must make a credible commitment to an enduring relationship with the supplier--it must build trust with the supplier. It can do this within the framework of a strategic alliance.

Alliances are not all good. Like formal vertical integration, a firm that enters long-term alliances may limit its strategic flexibility by the commitments it makes to its alliance partners. As we saw in Chapter 14 when we considered alliances between competitors, a firm that allies itself with another firm risks giving away key technological know-how to a potential competitor.