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Transaction Cost Analysis for Make-or-Buy Decisions

This research analyzes transaction costs to understand the factors influencing make-or-buy decisions, such as supplier competition and uncertainties in volume and technology. The study provides empirical results and implications for decision-making.

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Transaction Cost Analysis for Make-or-Buy Decisions

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  1. Group 3: Jason Franken Prasanna Karhade Hsiao-Ching Lee Marko Madunic, Jennifer Shen A Transaction Cost Approach to Make- or-Buy DecisionsGorden Walker and David Weber (1984)Administrative Science Quarterly

  2. Objective Supplier Competition Volume Uncertainty Make or Buy? Supplier Production Advantage Technological Uncertainty Buyer Experience • Analyzes transaction costs to inform understanding of important make-or-buy decisions. • Transaction costs influences on make-or-buy decision were assessed through the effects of supplier market competition and two types of uncertainties.

  3. Definitions • Make or Buy: A firm’s decision to manufacture components within the organization or to contract with outside suppliers • Volume uncertainty: Assessment of fluctuations in the demand for a component and the confidence placed in estimates of the demand • Technological change: Change in component design may induce the cost of re-tooling, re-contracting and administration. • Supplier production advantage: Comparative cost of production of suppliers • Supplier competition: Number of suppliers, competitive quotes, and suppliers proprietary technology • Buyer experience: The degree of similarity between tools and equipment and how a buyer has strong expertise in the technology required

  4. Motivation of this Research • Motivation • Maintains that uncertainty and asset specificity can influence a make-or-buy decision independently(different from Williamson’s (1975) framework, which emphasizes the interaction between uncertainty and asset specificity to explain and predict vertical integration) • Differences from earlier study by Monteverde and Teece (1982) • Focuses on simple parts associated with the initial assembly stage, which is different from the final product assembly stage (Monteverde and Teece 1982) • Includes production costs in their model

  5. Model • Eight Hypotheses are provided in their Model: • H1: Volume uncertainty Makeor Buy • H2: Technological uncertainty  Makeor Buy • H3: Supplier production cost advantage  Makeor Buy • H4: The competitiveness of the supplier market increases the production cost advantage of suppliers over buyers

  6. Model • Eight Hypotheses are provided in their Model: • H5: Greater supplier competition  Makeor Buy • H6: The experience of buyer producing a component reduces the production cost advantage of the supplier over the buyer • H7: Buyer experience in production  Makeor Buy • H8: Buyer experience in component production reduces technological uncertainty associated with the component

  7. Advantages and Disadvantages of Testing Theory • Advantages: • Hypothesized effects of variables on the make-or-buy decision can be assessed simultaneously with their influence on one another • The explanatory power of the model may be increased without decreasing its power to predict by building and testing the present model at a more general level than fine-grained descriptions of decision-making processes. • Disadvantages: • Small sample size drawn from a single corporate division limit the generalizability of the empirical findings • Relative simplicity of the components studied may explain to some extent the failure of part of the model

  8. Empirical Results Supplier Competition Volume Uncertainty Make or Buy? Supplier Production Advantage Technological Uncertainty Buyer Experience • Comparative production costs are the strongest predictor of make-or-buy decisions • Both volume uncertainty and supplier market competition have small but statistically significant effects

  9. Implications and Discussion • The effect of transaction costs on make-or-buy decisions was overshadowed by comparative production costs. • The level of market competition affected make-or-buy decisions indirectly • Mid-contract changes due to changes in demand were more perilous than changes in retooling. • Buyers pay for retooling • Less complicate design was involved in a simple component • Scale efficiencies may have been crucial for suppliers

  10. Implications and Discussion • Buyer experience on production costs has insignificant effect: • Relative simplicity of the components in this study • In addition, the relationship between buyer experience and production cost was based on the effect of the learning curve. • However, if in a complicate component which high technology uncertainty is involved, buyer experience may become significant. • How about other forms of buyer-supplier relationship? For example, tapered integration, JV and Kanban(JIT)?

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