In this lesson, you will learn about sourcing and strategic considerations associated with sourcing. So the question is why do supply chains exist at all? Why not have one single firm that controls the entire process from raw material to the final part? This is what is famously called the vertically integrated firm. And so the question that one has to ask is since there is profit to be made in every step of the process, why is it not best for a single entity to control all the steps of production? Now obviously, for any product if you ask this people will have fairly obvious reasons why you may not want to do this. For one, you may not have the expertise to do some of the tasks. So for example, if I'm making cell phones, I might be great at electronics, but I may not know how to make glass. And so it makes sense for me to go and get glass from someone else who knows how to make glass. So I may not have expertise, or I might be able to do it, but I am not very good at it. I don't have the competence. And so for me to do something might be too expensive. And so that may be another reason why I don't do it. So it's possible that someone else is able to do it at a lower cost. Now why might they be able to do it at a lower cost? Well, they're in a different area where labor costs are lower. Or they make tons of it so they have economy of scale, and that's why they can make it at a lower cost. It could be that I don't have enough capacity. Maybe I'm multi-talented. Maybe I have competence. Maybe I have expertise in everything. But I just don't have enough time or capacity to do this, and so I have to get it from somebody else. So it's fairly obvious that there could be lots and lots of fairly simple and logical reasons why we may want to get things from other people. But there's a problem. The minute I decide to rely on somebody else, I set myself up with certain risks. So for example, I rely on the glass manufacturer to provide the glass that goes on my cell phone. Now what if my glass manufacturer is late in providing me the glass? Now my product is late because I don't get deliveries on time. What if the glass manufacturer goes bankrupt. So by sourcing product from someone else, now I've exposed myself to a risk. I lose some amount of flexibility when I outsource. I now have to try and match my schedule against the schedule of my supplier. So the mere fact that I'm outsourcing now restricts me in certain ways. Now it's possible that the main problem with creating a cell phone is that you need to have to right kind of glass. So by going to a supplier for glass, it might now be easier for the supplier to realize, hey, I am making the main component. Why don't I just make the product? So in a sense, making of glass might be the core activity, for a cellphone it's very important thing. But it is not a core activity. But it could be and so loss of that core activity to a supplier would mean that I lose my entire business. Sometimes, I have to rely on a supplier because of capacity constraints. And when I do that I have to share information with them. Having this information allows that supplier now to be able to make the product. This is what's called intellectual property. It's hard to pass on information to someone and then expect that they will not try to use it for their own benefit. So this loss of intellectual property is a big concern when I decide to outsource to suppliers. And then, finally there are the typical risk, the financial risk that's involved because the supplier now is an external party on whom I'm relying. And the supplier is not financially sound then I expose myself to a financial risk as well. So there are a number of different risks that I find myself exposed to now, now that I've decided to get something from a third party. In fact, this is one of the main concerns why many companies are worried about outsourcing parts of their operation to other companies. So the question obviously one has to ask is when does it make sense to outsource and when does it make sense to do things yourself? And for the longest period of time it wasn't very clear why we organize ourselves in this particular fashion. Where we have suppliers and then we have buyers, which are two separate entities. And they trade with each other instead of just being one vertically integrated firm. And Oliver Williamson in the late 70s and early 80s came up with this theory called transaction cost economics. This is an economic theory that tries to explain how a firm should be organized based on the transactions that it has to undertake. When does it make sense to do certain things in house and be vertically integrated, when does it make sense to actually outsource? And if you do outsource, what kinds of precautions do you have to take? This theory has been so powerful that it earned Professor Williamson a Nobel Prize in 2009. So transaction cost economics looks at three attributes of every transaction. It looks at the frequency of the transaction. How often is this transaction made? It looks at what it calls asset specificity. So to do any particular transaction, you need certain skills, certain technologies, certain equipment, certain personnel. How specialized are these things that make these transaction possible? Both parties to a transaction bring something to the table in terms of these assets. How specific are these assets to this specific transaction? So for example, if I go to a woodsmith somebody who makes wood products. And I asked them to make a round bar of wood. Lots of people require round bars of woods, so the woodsmith has equipment that they use to make round bars. But lots of people require it. So my specific transaction of buying this thing from the woodsmith does not require the specific asset. On the other hand, if I want to order from this woodsmith, the same round wood bar with an extremely high level of polish on it. And that requires the woodsmith now to have very specialized equipment that nobody else requires for their round bars. Now there's a very specific asset that the woodsmith has to buy. And now this transaction requires a very specific asset. And so given that now I have a very specific asset that's required, my transaction is very different than when I was looking at buying just a simple word bar with no special finishing. So the specificity of the asset becomes very important. But this wouldn't matter as much were it not for the third characteristic of the transaction which is the uncertainty that's involved. And what do we mean by uncertainty? Now, when we think of uncertainty, there are obviously environmental uncertainties that might exist. For example, it could be that the work that my woodsmith gets, the quality of that work could be uncertain. Sometimes it's good quality, but sometimes it's bad quality. It's possible that the woodsmith gets busy certain times, and so the woodsmith is late in delivering the product to me. So there are uncertainties involved with that, but there are also other uncertainties. For example, the woodsmith when he has to buy this particular product which puts this high finish on the rod that I'm buying. The woodsmith now has to wonder I'm going to invest in this particular equipment it's going to cost me a lot, it's only specific to this one particular customer. What is to say that this customer won't turn around and stop ordering from me and I'm left with this equipment? So the woodsmith has no way of knowing or predicting the behavior of the buyer. Ultimately, it could be that this piece that I'm buying from the woodsmith is a very important part to a larger project that I'm doing. And now I have to worry whether the woodsmith is going to hold me ransom. The woodsmith knows that the woodsmith is the only one with this particular asset and there is no one else with this particular asset. And so they're the only ones who can provide me with this thing. And so what is to prevent them from holding me ransom when they try to deliver the product and say no, you gotta pay more for my product. So there's an uncertainty that's created. And the fact that this uncertainty may or may not be resolved changes how we think about our transaction. Now of the three things that we looked at, the three attributes, the one that is considered the most important is asset specificity. And the reason for it is that it creates this unique imbalance in the transaction. And so we talk a little bit more about that. But when we think about this transaction now with its three different attributes, we have to start thinking in terms of well, why does this matter? Well, it matters because now, whenever we make a transaction, there's a cost associated with making this transaction. So when I buy the piece of wood from the woodsmith, the cost of the wood is just one of the cost associated with buying this particular product. There are other costs now associated with this transaction. I want to find a woodsmith who has the capability to produce that fine finish on this roll that I'm going to be buying. So there's a cost associated with identifying the right suppliers. I may have costs associate with finding what is the right price I ought to be paying for this particular product? I may have to specify what the right quality I need to check whether that quality is actually provided. I may have to worry about the durability of the product that is being given to me. There are other costs that are the transportation costs associated with moving that product from the woodsmith to my factory or my facility. There are legal costs because soon as I decide to do this, I have to sign the contract, to sign the contract I need to get some legal representation. So there's a cost associated with creating a contract to take care of the fact that the woodsmith may not be able to provide me the things in time that may cause severe damage to my business. I may need to ensure against the eventuality that this uncertainty doesn't actually materialize and so now I have insurance costs. So the simple transaction that we were looking at has a lot of different costs that are now associated with it. To do our business so that we can add value without significantly adding cost, we have to look at what is the best way to organize ourselves so that these transaction costs are minimized. And that's what we talk about in transaction costs economics.
