BA220 Week three chapter 5 ppt
- 1. Strategy Theory and Practice © Stewart R. Clegg, Christos Pitelis, Jochen Schweitzer & Andrea Whittle
- 2. Chapter 5 Strategy: Make or buy?
- 3. Learning objectives • Understand the importance of transaction costs in determining the strategic decision of whether to integrate (‘internalize’) or outsource (‘externalize’) • Explain the key concepts used in Transaction Cost Economics, including transaction frequency, bounded rationality, opportunism, feasible foresight, uncertainty and asset specificity • Identify the difference between vertical and horizontal integration 3
- 4. Learning objectives • Understand when and why firms integrate horizontally (merge or acquire another firm in the same line of business) and the challenges of achieving horizontal integration • Explain the advantages and disadvantages of outsourcing 4
- 5. Horizontal/vertical integration and outsourcing • Horizontal integration occurs when a firm acquires or merges with another in the same industry • Vertical integration involves moving into activities that were previously an input into the firm undertaken by one’s suppliers ‘downstream’ (known as backward integration) or part of the post-production process undertaken by buyers ‘upstream’ (known as forward integration). • Outsourcing involves moving activities that were previously undertaken by the organization to outside suppliers as contractors. 5
- 6. Transaction cost economics (TCE) • TCE started life in a 1937 paper by Ronald Coase and was developed further by Oliver Williamson • Williamson drew on concepts developed by behavioural theorists such as Herbert Simon and Cyert and March • Williamson outlined the alternative models for economic activity: – market (buy) – hierarchy (make) 6
- 7. To make or buy? That is the question • Madhok and Tallman (1998) outline four factors to consider in deciding whether to make or buy: • Lack of necessary internal capabilities and assets • Unavailability of needed resources for purchase in the open marketplace • High cost or risk associated with purchasing a firm that has the necessary resources • Benefits of collaboration, such as evading extensive organizational integration following a merger or an acquisition and the preservation of critical assets and strategic flexibility 7
- 8. Transaction costs • The economic costs that are incurred when exchanging (buying or selling) goods or services. 8
- 9. Organizational boundary decisions • According to TCE, the boundary of the firm is a result of economic considerations concerning ‘make or buy’, that is, internalizing or externalizing activities 9
- 10. Asset specificity • The degree to which an asset can be redeployed to alternative uses without loss of value 10
- 11. Williamson and TCE • Williamson’s (1981) development of Transaction Cost Economics (TCE) focuses on efficiency • Efficiency is defined in terms of reductions in transaction costs • The key question TCE raises is whether transactions should be coordinated within a firm or across markets: – Is a transaction more efficiently performed within a firm through its vertical integration inside? 11
- 12. Williamson and TCE – Is a transaction more efficiently performed within a firm through its vertical integration inside? – Or should the firm use market mechanisms by buying it from the outside from autonomous third-party contractors? – Hence, whether to make or buy? 12
- 13. TCE proposes that human actors are characterized by • Bounded rationality (all complex contracts are unavoidably incomplete because the buyer and seller cannot know in advance and write in the contract all possibilities of what might happen when they exchange the goods or services). • Opportunism (the assumption that parties of long-term contracts will breach the spirit of a contract if it is in their self-interest to do so). • Feasible foresight (the principle that parties to a contract have the capacity to look ahead and to integrate those insights into the ex-ante decisions, for example by setting up contractual safeguards). 13
- 14. Bounded rationality • Bounded rationality is a term taken from March and Simon (1958) • It acknowledges the fact that we never have perfect knowledge and hence can never be perfectly rational • Because rationality is always ‘bounded’, it leads to parties not being able to foresee all the possible consequences of a contract 14
- 15. Opportunism • Opportunism prevails when: – actors try to gain advantage by being economical with, or even distorting, what we take to be the ‘truth’ – the possibility of opportunism ensures that there is also the possibility of uncertainty about agreements being maintained (for example, a buyer not paying for something bought on credit) 15
- 16. Factors predicting firm formation 16
- 17. Uncertainty • Uncertainty is associated with the unfolding of events relevant to contracts, the contingencies of which cannot necessarily be controlled • Uncertainty is positively related to hierarchical governance, due to the power of managerial fiat (Williamson, 1975, 1985) 17
- 18. Three types of uncertainty • Volume uncertainty – being unable to predict the amount of materials needed • Technological uncertainty – being unable to forecast technological requirements • Behavioural uncertainty – being unable to predict or control the behaviour of the other party 18
- 19. Asset specificity/transaction frequency • Asset specificity refers to the degree to which an asset is specific to use or user • Transaction frequency refers to the repeatability of transactions (i.e. how often transactions occur) 19
- 20. How hierarchies solve the market failure • Hierarchies solve the market failure problems that result from contracting through (vertical) integration in three ways – Information flows. – Negotiating costs. – Incentive alignment 20
- 21. Market failure • Information flows – You can gain access to information more easily if you bring it in house – By doing so, you can have better auditing capacity to receive critical information and impose controls – You can also tell staff how to keep their books • Negotiating costs – You can also reduce the costs of negotiation. Hierarchy imposes a system of authority that is characterized by a unilateral dispute mechanism 21
- 22. Market failure – People in authority positions can say how to do things and get them done • Incentive alignment – Through vertical integration, there is no longer any incentive for a firm to not make investments in specialized assets – Once the same firm owns everything, opportunism in the ownership and control of specialized assets will not occur – So vertical integration brings about an incentive realignment 22
- 23. Concurrent sourcing • Firms can both make and buy the same good, using ‘concurrent sourcing’ • Concurrent sourcing is used in situations when, for instance: – demand uncertainty pushes fluctuations in volume onto suppliers in order to ensure full internal capacity and stable production – the use of both owned and franchised outlets balances incentive and control issues, as well as facilitating learning 23
- 24. Concurrent sourcing – abundant raw materials or subcontractors are readily available and physical interconnectedness is unnecessary – high economies of scope of both buyer and supplier and diseconomies of scale are insubstantial, so that bargaining power is strengthened by the opportunity to benchmark and better evaluate the performance of internal and external suppliers 24
- 25. Applications of TCE • The multi-divisional (M-form) organization simplifies the informational and decision-making situations by clearly differentiating between the long-range policy decisions to be handled by the general office and the short-term operational decisions to be determined at divisional level • Business units become profit centres, and the Head Office an internal capital market that receives profits and allocates resources 25
- 26. M-Form • From the TCE perspective, the M-form (internal capital market) possesses important advantages over the external capital market: – It has easy access to more accurate information about divisions. – It can manipulate incentives more easily. – It can exercise control over the strategies pursued by divisions. (Barney and Hesterly, 1996) 26
- 27. M-Form 27
- 28. Problems with TCE • The market and hierarchy distinctions that TCE sculpted, have blurred: – Coopetition refers to cooperation designed to provide mutual gain between businesses that have previously seen each other as competitors – Emergent forms of networks, such as in the field of open- source software or, more recently, in some manifestations of the sharing economy, challenge the ideas of embeddedness and knowledge networks 28
- 29. Problems with TCE • TCE does not explain how that market came into being • TCE assumes firms have an effective hierarchy and agreement on goals • TCE understates the cost of organizing – including costs of haggling and transactions within the firm • TCE’s view of economic activity remains too rational – firm behaviour is not always rational and driven only by cost • TCE neglects the role of social relationships (‘embedded ties’) in economic transactions 29
- 30. Embeddedness or ‘embedded ties’ • Refers to the way in which economic activity is influenced or constrained by non-economic institutions, such as kinship relations, religious institutions or political institutions. • These ‘ties’ mean that economic activity is not guided by rational economic calculations of maximising payoffs, but rather is guided by norms and values shared by the social group or by political or religious belief systems. 30
- 31. Coopetition • … refers to the coexistence of cooperation with competition between businesses aiming to take advantage of the benefits of both 31
- 32. Vertical and horizontal integration 32
- 33. Integration • TCE considers two major forms of governance for integrating (or internalizing) transactions within a firm: – Horizontal integration occurs when a firm acquires or merges with another – Vertical integration involves moving into activities that were previously an input into the firm undertaken by your suppliers ‘downstream’ (backward integration) or part of the post-production process undertaken by your customers ‘upstream’ (forward integration) 33
- 34. When to vertically integrate? • Vertical integration is more likely when: – There are common systems, standards and protocols used by both parties, making ‘joining up’ easy o Locating manufacturing outside the firm can make cross-functional coordination much more difficult, given the probability that locally differentiated systems will be in use 34
- 35. When to vertically integrate? – Integration can provide enhanced information transfer and coordination across activities o With technologies that require a great deal of coordination, it makes sense to try and secure these in-house, inside the organization 35
- 36. When to horizontally integrate? • Horizontal integration is more likely when: – It provides advantages such as: o reducing competitive intensity o lowering production costs through scale o boosting differentiation by eliminating similar products or services in the market o providing access to new markets and distribution channels (especially important for internationalization strategies) 36
- 37. When to horizontally integrate? • Reducing competitive intensity can change the underlying industry structure by taking out excessive capacity from rivals and increasing industry consolidation 37
- 38. M&A • Mergers involve two firms combining to create a new legal entity. • Acquisitions involve one firm purchasing another firm, meaning the acquired firm ceases to exist. 38
- 39. Cultural integration • ‘Cultural integration is said to occur when changes are made in two different cultural systems because particular elements of culture have spread from one system to the other, in both directions’ (Berry, 1980: 215) 39
- 40. Acculturation • Van Marrewijk (2016) identifies four strategies for acculturation: – Integration: when the two cultures are integrated, each retains its individual identity (Buono and Bowditch (1989) define four strategies for integrating cultures in M&A: taking over, blending, pluralism and resistance) – Assimilation: when one culture absorbs the other – Separation: when two cultures are entirely separate – Deculturation or marginalization: when a culture disintegrates 40
- 41. Outsourcing • Outsourcing is the mirror image of integration • Activities previously done in the firm are moved out to a contractor • The growth of web-based and digital telecommunications services enables more activities to be outsourced by lowering transaction costs 41
- 42. Problems with outsourcing • Cost reductions are often over-estimated because of poorly specified calculations • Outsourcing causes additional costs: o management costs in examining and deciding on tenders o employee costs in packaging and transferring information o legal costs in resolving disputes 42
- 43. Problems with outsourcing • The additional costs associated with outsourcing mean that companies need several years to realize the financial benefits • Cost savings often occur at the expense of a reduction in quality, a deterioration in work conditions and a decrease in employment 43
- 44. Conclusion • You should now know about: – Transaction Cost Economics (TCE) – Vertical and horizontal integration – The importance of culture in horizontal integration – Outsourcing 44
- 45. References • Barney, J.B. and Hesterly, W.S. (1996) ‘Organizational economics: Understanding the relationship between organizations and economic analysis’, in S.R. Clegg, C. Hardy and W.R. Nord, Handbook of Organization Studies. London: Sage Publications. • Berry, J.W. (1980) ‘Social and cultural change’, in H.C. Triandis and R.W. Brislin (eds), Handbook of Cross-Cultural Psychology. Boston: Allyn & Bacon. pp. 211−279. • Buono, A.F. and Bowditch, J.L. (1989) The Human Side of Mergers and Acquisitions: Managing Collisions between People, Cultures and Organizations. London: Jossey-Bass. 45
- 46. References • Madhok, A. and Tallman, S.B. (1998) ‘Resources, transactions and rents: Managing value through interfirm collaborative relationships’, Organization Science, 9(3): 326–339. • March, J.G. and Simon, H.A. (1958) Organizations. New York: Wiley. • Van Marrewijk, A. (2016) ‘Conflicting subcultures in mergers and acquisitions: A longitudinal study of integrating a radical internet firm into a bureaucratic telecoms firm’, British Journal of Management. doi: 10.1111/1467-8551.12135. 46
- 47. References • Williamson, O.E. (1975) ‘The economics of governance: Framework and implications’, Journal of Theoretical Economics, 140: 195–223. • Williamson, O.E. (1981) ‘The economics of organizations: The transaction cost approach’, American Journal of Sociology, 87(3): 548–577. • Williamson, O.E. (1985) The Economic Institutions of Capitalism. New York: Free Press. 47