[IS Theory] A transaction cost approach to make-or-buy decisions

Walker, G., D. Weber, “A transaction cost approach to make-or-buy decisions,” Administrative Science Quarterly, 1984, pp. 374-91.

- Williamson's model indicates that when asset specificity is low, suppliers enjoy a production cost advantage over buyers, since they are able to pool possibly uncorrelated or negatively correlated demand and thereby achieve smoother production schedules and greater economies of scale.

- The production cost differential decreases as roughly an inverse function of the increase in asset specificity and approaches zero, never favoring the buyer.

 - A comparison of transaction costs between making and buying indicates that the firm should bring the operation in-house at a relatively early point (A) on the asset-specificity continuum.

However, because production costs favor the supplier at this point, buyers should continue to purchase the component until the sum of the production and transaction cost differentials at

A' points to their making the component.

 

- In the model, the influence of uncertainty on transaction costs is held constant at a moderate level.

- According to Williamson's model, uncertainty and supplier asset specificity are joint conditions for a decision to make a component.

- Two types of uncertainty -volume and technological –are identified here.

 1) Volume uncertainty depends on the assessment of fluctuations in the demand for a component and the confidence laced in estimates of the demand.

   - When volume uncertainty /s high, suppliers experience unexpected production costs or excess capacity and buyers experience stock-outs or excess inventory. These events increase transaction costs because of mid-contract renegotiation.

  2) Technological change in component design requires retooling, which in the present case is paid for by the buyer, and re-contracting with the supplier, if the component is currently purchased.

    - as the frequency of technological change increases, the administrative costs of managing the interfaces between in-house engineering, purchasing, and outside suppliers may become higher than the administrative costs