So let's look at the decision we have to make of whether we should actually go to a wordsmith and buy this thing from the wordsmith or buy the equipment and put it in the house and then make this particular product ourself. And to do this, we'll look at two of those attributes; the frequency attribute we'll talk about briefly but the more important ones are the asset specificity and uncertainty. So, on this graph that we have right now, let's put the x-axis as being the amount of uncertainty and the y-axis as being the asset specificity. So, we can have low uncertainty on the x-axis and high uncertainty. So, on the left we have low uncertainty, on the right we have high uncertainty. And on the y-axis with assets specificity, similarly at the bottom we have low uncertainty and at the top we have high uncertainty. Now, if you take the case where asset specificity is low and uncertainty is low. In this case, there is no real reason why there's any benefit for us making this part up in-house. Giving it to a supplier who might be able to do it at lower cost may be perfectly a reasonable thing to do because the cost of doing this transaction is relatively low. The supplier already has the ability to make this. They don't need to buy a very specialized equipment to make this product and I don't have to worry about them feeling me very much so that the actual cost of making this transaction is very small, it's almost frictionless and now if the supplier is able to provide this product to me at a lower cost, there is no reason for me to make it. And so, the obvious choice is to buy. Let's go to the other extreme, and let's say asset specificity is very high and the uncertainty is very high as well. So what do we mean by this? So, let's say that I am going to have this product manufactured in a third country. The supplier in that country would have to be given quite detailed information about my product to actually make this particular product. So, I'm bringing some intellectual property to this part of this product to this transaction. This intellectual property is specific to my product. So there is high asset specificity, the intellectual property here is the asset that I am concerned with. Now, let's say that this third country that I'm looking at, this supplier country, has very poorly developed legal system. So that even if I sign a contract with the supplier that says that they cannot use my information for anything else other than for making my product, I have no way of enforcing the contract because I don't know whether the courts will uphold my contract or whether they won't. So now, I have very high uncertainty. In this case, I'm bringing very specific assets to the transaction and I have a high amount of uncertainty. Clearly, asking this supplier in this country to make it for me would be a very risky proposition and the chances are that I might lose my intellectual property. In this case, even if it is possible that the supplier is able to supply this thing to me cheaply, I might prefer to make it in the house. In fact, I should prefer to make it in the house because there's a very good chance that I might lose everything in this transaction because of the higher asset specificity and the high amount of uncertainty that's part of this transaction. So at the two extremes, the answer is relatively clear. From a strategic point of view, if asset specificity is low and uncertainty is low, I ought to buy. If asset specificity is high and uncertainty is high, I have to make. In between, there's a continuum where what does it mean to be low and high in any case? These are sort of arbitrary things that we are talking about of something being low and something being high. Most companies are able to figure out what kind of risk are they exposing themselves in each of these situations. And so, what happens is that for the pop things in between, we have to come up with different kinds of supply partnerships. We have to look at what might be the best way to deal with this? What kind of contract might have to be signed if I want to actually get a supplier to provide me with this product? Okay. So we've kind of looked at the diagonal but let's look at the other colors. What happens, for example, if I have high asset specificity, but uncertainty is low. So for example, I bring intellectual property to the transaction and have a supplier make it. But the supplier is at the country with strongly developed legal system. So that now if I sign a contract with the supplier, I can actually enforce that contract. So that if the supplier decides to break the contract and use my asset for something else, use my intellectual property for something else, I can actually take them to court and make them pay. Now clearly, there's a cost associated with this transaction, but it may be possible that I can still do this because the supplier is able to provide me things at a much lower cost and so I need protection from the supplier using my intellectual property but the uncertainty is low because I know any protection that I get which involve the cost is enforceable. Now lastly, what happens if I have, I go to the last column and I say what happens if my asset specificity is low and my uncertainty is high? Now, in this case, a lot depends. It depends on how many suppliers that are in the market. It depends on how important this product is for me. It might depend on is this a new technology that I'm going to be developing that can be used in the future and might become important to me in the future. Is it something that I'm experimenting with? Because notice that the fact that its low asset specificity means that neither party to the transaction is bringing anything that needs to be protected against the uncertainty. And so at that point, there are a variety of different choices that we may make. It's not clear whether we should buy or make and it might depend on the circumstances. Let's try and take this transaction cost economics theory and see how it applies to our make or buy decision. So when we decide whether we want to make or buy a product, we have to look at it from three perspectives. There's a strategic perspective that we have to take, which basically looks at the overall or the overarching importance of this decision to our enterprise. We have to look at the risks that might be involved and then finally, we have to look at economic considerations when we decide whether we're going to do this or not. Now, if I have a process or a product or service that I'm looking at either outsourcing or doing in house, if this particular product or service allows me to differentiate my product or service in the market, then outsourcing it may not be the best idea. So for example, if I have come up with a recipe to make a secret barbecue sauce, which is the best in the world, now for me to make it, I don't make a lot of barbecue sauce. But for me to make it, it's expensive. I have to buy all the ingredients at retail prices to do this. It might be cheaper for me to outsource it to someone who can get the ingredients at a wholesale price and do it cheaper. But the minute I do it, my secret sauce is no longer secret. And so I might want to keep the making of this particular barbecue sauce in house. If I find that what I'm looking to outsource provides me a way to differentiate my product or service, then keep it in-house. Perhaps that may not be a reason. Perhaps this is not a secret sauce. Okay. Okay. But what I find is that being able to do this, I have many businesses that I grew this across. Even though this is not a key differentiator of my products or services, I needed across many of my businesses. So in that particular case, I look at it and I have enough volume across many of my businesses that I might still want to keep doing it. What about the case where I can get things from a supplier? For the supplier is my competitor. So in a sense, my suppliers are hostile to me, I'm at risk. Because I've now created a situation where my supplier could turn around on me anytime. So, in that case I might want to make. Finally, it might be that I need to improve my technology. It might be that I make cell phones when I don't make glass but the class that's made by my supplier is not very good and I need to make better quality glass. I need to have a glass that I can throw against the wall and nothing happens to it. But my supplier is not willing to do it. So, I need to push the technology envelope on making this glass. So, I need to make in-house so that I can push the technology in them. On the other hand, when I'm outsourcing, I look out and I notice that the making of this product or adding the service is not a particularly attractive business or the production environment in which I have to make this is not particularly attractive. For example, I might have to take products and print them chemically and that creates fumes and I might not think that that's an environment that I want to create in my factory and so I might decide to outsource. So, it's not a business I want to be in, it's not something that's important to me, I want to outsource it. It's possible that the end product that we are looking at may not be critical to my business. If I'm making an electronic gadget, the power cord that goes from the electronic gadget to the walls to power of this gadget, that cord is not an important enough product I can let somebody else make it. If I think of power cords, there are a lot of suppliers who make these power cord. They're very good at it and they make it in volume and so the supply market for this power cord is dependent. So, in that case, for strategic reasons, I don't want to be involved in making power cords. It's also possible that my suppliers are quite innovative. So, if I'm looking at this piece of glass, if my glass suppliers are constantly coming up with better and better glass, there's no need for me to get involved because this is not core to my business. So, at a high level I want to think strategically and say does this make sense for my business to make our buy? Then I need to consider what are the risks. So for example, if there are very few suppliers in the market, what happens if one of the suppliers decides to stop supplying us? We may then find that outsourcing a component from that supplier is risky. What happens if suddenly technology changes and the rest of the market is able to make it cheaper? Now, I'll have invested in equipment and that might be a problem. I then need to look at whether there's a need for quick response. Oftentimes the market that I am in may need me to react quickly and so in that case I might decide that I should make it in-house. Lastly, there's risk to my intellectual property. So, asking somebody else to make a product if that risks intellectual property, I may not be willing to take the risk because loss of that intellectual property could mean my entire business suffers. Contrast that with what happens when you outsource. So, the risk that a supplier would hold-up deliveries for whatever reason if that risk is manageable. Why? Because there may be multiple suppliers and the supplier is worried that you could easily go to a different supplier, in which in that case I'm okay to outsource. If it's easy for me to switch suppliers, if the switching costs are not particularly expensive, I might decide to outsource. And the lead time for the product are small. So, if I'm buying a product that's a commodity product that's easily available then I can go to the market and buy it immediately, then again I might outsource. Finally, counter to the way we talked about intellectual property, if there is no intellectual property risk involved then obviously it makes sense to outsource. Lastly, after we've sought of negotiated our way through the strategic part of this decision and after we've considered the important risks that we may be taking, we come to sought of economic analysis. Oftentimes when people learn about make or buy decisions they only think about the economic analysis. Now, the typical economic analysis says, "Can I make things cheaper in-house or is it cheaper to make it elsewhere?" Now obviously if it's cheaper for me to make it then I will make it, if it is cheaper to outsource it then I might allow the supplier to make it. What costs ought to be considered when making this analysis is tricky sometimes. Because apart from the direct material cost and the indirect costs et cetera, there are opportunity costs. Do I want to spend time worrying about the making of bolts in my very high tech factory even if it's cheaper for me to make it or do I allow somebody else to make it even if it's marginally more expensive because the opportunity cost is higher. I could be using the time and effort that we are putting into manufacturing of bolts into making a more high value product. So, it's not just looking at the cost of making that particular item, it's the benefit of doing something else. Now, there may be other reasons why I might make it. It might be more expensive for me to make the bolt in-house but I've already invested in a large screw machine, machines that make screws and this is an extra thing that I can make on it which helps me pay for this prior investment. In that case, I should try and make it to make use of the capacity that I have on hand. Conversely, if it's going to require me to make a major investment even if it's going to be cheaper, I might look at it and I might decide that it probably doesn't make sense to make a major investment in this and let someone else do it. Finally, I have to look at the competence of my organization. If I have significant skills and significant expertise in making something, then obviously I ought to be making it. Usually, when I have that skill and expertise, usually make costs are lower, usually I have other equipment et cetera, that is required to make this particular product available. Or if I have poor in-house skills. So for example, I know that I could chemically create some sheet metal parts in-house. I know if I did it it would be cheaper but I don't have anyone who's experienced in doing this in my organization. Now obviously I need to recruit someone, bring them in and I might still be able to make it work. Or I might decide that I don't have the in-house skills for this, I might as well go to someone else who does this on a regular basis and who has a lot of expertise in it and let them do it rather than me do it. Even though if I did it I might end up saving or being economically illiterate background because there are a lot of hidden costs associated with managing a new enterprise or a new effort within your own organization. So, the make or buy decision then sought of follows these three-tiered approach where we think of things strategically, we evaluate the risks, and then we look at the costs associated with it. In the 1990's early 2000's, there was a big move for companies to move production out of their own facilities and outsource it and often offshore it to low labor cost countries. What many of these companies found is that even though they were able to get things relatively cheaply, a large number of them found that they wanted to bring back or cancel those offshoring engagements and bring back the production either in-house or going onshore location. Because the cost advantages often they're obvious upfront but there are a lot of hidden costs of actually doing the transaction, of having to monitor the process, of having to ensure quality, of having to worry about reputational risk than a by-product was shipped by the supplier. Lastly, the fact that you could actually have an IP lost or intellectual property might be lost was a big concern for many of these companies and some of them did actually lose intellectual property. So, there was a trend to sought of move back and many of those initial outsourcing contracts or offshoring contracts were cancelled. Now remember outsourcing does not necessarily mean offshoring. Outsourcing means allowing someone else to provide you with the product or service. Offshoring is where that someone else, the counterparty is located in a different country. Usually in a low cost country typically in Asia or Africa. So, people may still outsource, but they may choose to instead of doing it offshore they may do it onshore which means if you're in the United States you outsource to a supplier that's within the United State. If you're out in Europe you outsource to somebody who is within Europe and so on.
