Make-or-buy business

“Make-or-buy is a business decision that compares the costs and benefits of manufacturing a product or product component against purchasing it. If the purchase price is higher than what it would cost the manufacturer to make it, or if the manufacturer has excess capacity that could be used for that product, or the manufacturer’s suppliers are unreliable, then the manufacturer may choose to make the product. This assumes the manufacturer has the skills and equipment necessary, access to raw materials, and the ability to meet its own product standards” (www. answers. com).

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Businesses across sectors have been facing a classic decision point for generations: Should they make? Or should they buy? More importantly how does problems like agency relationships; asymmetric information and adverse selection affect a firm’s to make this decision. Reasons that firms should buy include firms in a market may be able to achieve economies of scale, and there for offer a cheaper price for the products. Also such firms may have experience and information that helps them produce at a lower cost. Due to this experience firms in markets can exploit this and obtain learning economies.

(Besanko, 2007) However there are also advantages for firms to produce their own products. Producing your own products helps flow of products from one stage to another; there may be delays if products are bought from independent market firms. Moreover private information of products, markets etc may be leaked to the independent marker firm. Costs of working with such firms may also be high and it may be cheaper to perform these tasks in-house. (Besanko, 2007) So what problems affect their decision whether to Make or Buy? Agency Relationships

To understand agency relationships the principle agent theory will be used. The principle-agent problem arises in a situation where principle who has to a hire an agent (manager) to work on their behalf (Begg 2004. ) An introduction of an agent may be due to an agent having specialised knowledge in a certain area, saving the principal a great deal of time and effort. In this case, outsourcing to an independent firm, with them being the agent. This is where the problem arises, because the company is now relying on the independent firm.

They want the firm to further their interest not to have some hidden action that will further the firms own interests. This is known as the moral hazard (Begg 2004. ) Here lies the problem the independent company may chooses act on its own interests and consume more time and money, and maybe meet fewer requirements. The principal is limited in his ability to monitor the independent companies output and input. This leads to mistrust between the companies. (Keil, 2005). This leads to agency costs, agency costs are costs related to slack effort and administrative costs to control it.

The fact that they have to deal with this by monitoring alone is costing the company money. Agency costs are determined by 5 factors, outcome uncertainty, risk aversion, programmability of the task delegated, outcome measurability and length of relationship (Barrar 2006. ) If you consider call centres, many companies like British Gas would outsource customer management teams, because they feel it cheaper. Ventura in Leeds is a perfect example of this. However British gas would not be able to monitor, how the staff are doing.

This responsibility lies on Ventura who may not see it in best interests on wasting time and money in doing so, although complaints may increase due to this. Out come based contract Asymmetric information. The definition of asymmetric information can be as simple as to say the disequilibrium of knowledge between one party and another. In this situation it means the agent knows more about the situation than the principal does (which ironically may be why the agent had been employed in the first place, for her/his specialised knowledge).

If you consider Akerlof Market for Lemons paper who illustrates this by using a car example, consumers buying second hand cars are unsure of the quality of the owners car. As a result of this, estimating a price for car becomes difficult. The owner of the car is the party with the information; and knows whether the car is in good or bad condition. The buyer however knows little about the car and so cannot value of the car. A good car is worth more than a bad car, and so if the buyer’s willingness to pay for the car is at a lower price, then the owner may not want to sell the car, as it does not reflect the true value of the vehicle.

Only the cars that are at a lower price will sell, hence the lemons. The presence of inferior goods destroys the market for quality goods when information is imperfect and relates to Greshams Law. The danger lays in the situation where the agent may not act in the principal’s best interest and may be able to get away with doing so because of the principals inadequate knowledge and inability to monitor effectively the day-to-day running of the firm. Information asymmetry can lead to moral hazard and adverse selection (Shi et al, 2007. )