A Transaction Cost Approach to Make-or-

Buy Decisions.

A Paper SummaryBy – Amit Darekar

Gordon Walker and David Weber,

Administrative Science Quarterly. September, 1984

Problem at hand….

• Make-or-Buy decisions as a paradigmatic problem for analyzing transaction costs

• Focus on the prototypical choice between making a component within the firm or buying the component in a market partly regulated by competitive forces.

Hypotheses1. Volume uncertainty leads to making rather than buying a

component.

2. Technological uncertainty increases the likelihood of a make rather than a buy decision

3. The higher the supplier production cost advantage, the more likely the firm is to buy rather than make a component

4. The competitiveness of the supplier market increases the production cost advantage of suppliers over buyers

5. Greater supplier market competition should lead to buying the component.

6. The experience a buyer has in producing a component reduces the production cost advantage of the supplier over the buyer.

7. Buyer experience in producing a component increases the likelihood of a buy decision.

8. Buyer experience in component production reduces technological uncertainty associated with the component.

Assumptions

1. Asset Specificity and uncertainty are allowed to influence make-or-buy decisions independently

2. Sufficient uncertainty was inherent in all transactions included in the study, therefore any increase in asset specificity would tend to increase transaction costs

3. Types of uncertainty influenced transaction costs independent of the level of asset specificity.

4. Types of uncertainty: 1. Volume uncertainty

2. Technological changes

5. The costs of administering inter functional coordination within the firm were virtually independent of the transaction costs associated with contracting in the market

Model Developed…

• The model constructed was a structural equation system with observed and unobserved variables.

• All constructs, except the make-or-buy decision itself, were indicated by more than one observed variable.

• These constructs were measured using following indicators– Volume uncertainty

– Technological uncertainty

– Supplier production advantage

– Competition among suppliers

– Buyer experience

7

SupplierCompetition

Buy decision

SupplierProductionadvantage

Positiv

e

positive

Buy decisionVolume

uncertainty

Technologicaluncertainty

negative

negative

Buyerexperience

positive

positiveNegative

Negative

Full model

Data and Methods…

• Sample in this study consisted of relatively simple parts associated with the initial assembly stage

• The data consisted of 60 decisions made in a component division of a large U.S. automobile manufacturer over a period of three years

• Structure Equation Model (SEM)

• The data were analyzed using the unweighted least squares (ULS) procedure of Joreskog and Sorbom (1982)

9

11

SupplierCompetition

(reverse scale)

Buy decision

SupplierProductionadvantage

Volumeuncertainty

Technologicaluncertainty

Buyerexperience

-.284*

.034.155

-.198

-.315*

-.316*

.205*

.86

2*

Results

Results• The hypothesis about the effect of the production

advantage of the supplier on make-or-buy decisions was strongly supported

• The effect of supplier competition on production advantage was moderate and had an acceptable critical ratio

• The direction of the effect of buyer experience on comparative production costs is negative, as hypothesized

• The results show that the effects of competition and buyer experience were relatively small and that only market competition had an acceptable critical ratio for the jackknife coefficient. Both effects indicated a buy decision as hypothesized.

• Of the two types of uncertainty studied here, only volume uncertainty had a significant effect in the predicted direction

Results (Mixed support for Williamson’s theory)

H1/r1 Volume uncertainty leads to making rather than buying a component. Significant effect

H2/β1 Technological uncertainty increases the likelihood of a make rather than a buy decision.

direction opposite to hypothesis; not significant

H3/β2 The higher the supplier production cost advantage, the more likely the firm is to buy rather than make a component.

Strongly supported

H4/r2 The competitiveness of the supplier market increases the production cost advantage of suppliers over buyers.

moderate

H5/r3 Greater supplier market competition should lead to buying the component.

Jackknife coefficient acceptable

H6/r4 The experience a buyer has in producing a component reduces the production cost advantage of the supplier over the buyer.

Jackknife coefficient not acceptable; variance explained low

H7/r5 Buyer experience in producing a component increases the likelihood of a buy decision.

Not significant; small effects

H8/r6 Buyer experience in component production reduces technological uncertainty associated with the component.

Moderate; variance explained low

Discussion• The results show mixed support for Williamson's (1975)

theory.

• The effect of transaction costs on make-or-buy decisions was substantially overshadowed by comparative production costs

• The extent to which market competition affects make-or-buy decisions may reflect the ability of the component purchasing manager to indicate how low competition leads to contracting difficulties

• A reasonably confident inference can be drawn that the supplier production advantage construct is relatively uncontaminated by transaction costs associated with the buyer-supplier relationship.

• Small sample size (not a random sample)

• Simple components

• “Common method bias”