Value chain & system of activities: vertical integration - part 2 (Antonio Ghezzi) - YouTube

Let’s consider the pros and cons of the make choice, which means carrying out activities

within the company, in turn increasing the company’s vertical integration level.

A first advantage will be the dropping or disappearing of transaction costs:

but what are transaction costs?

They are the costs to be borne in order to work with the external market, to carry out

a commercial transaction with one or more third-party suppliers.

If I can perform an activity within the company, I will not need a supplier and I will eliminate

costs for scouting, evaluation and selection of suppliers (let’s consider, for example the vendor-rating process)

as well as administration and legal costs (like costs to draft a contract) and potential logistic costs.

A second advantage, at the same time, is that I will internalize the supplier’s margin,

as I will have to pay no margin to third parties.

The only costs borne in this make option are internal costs for performing and managing activities.

Other advantages are the increased control on activities’ costs, guaranteed by direct

execution, together with better control and development of potential core resources

and skills linked to the internalized activity itself, like know-how or adopted procedures,

which over time, will be otherwise acquired and covered only by suppliers.

A last advantage of the make-option is the elimination of the problem of reliance on

the supplier, which often leads to the company losing sight of real costs of the activity

and to weakening control of resources that are possibly key for competitive advantage.

The make-option has nevertheless also a number of disadvantages, which also dually represent

the advantages of the buying or outsourcing option.

First of all, our company could be less efficient than a given external supplier in carrying

out the activity, due to the effect of “scale economies” and “experience economies”.

Suppliers are likely to carry out the same activity for a number of customers and will therefore

have a higher scale and learning speed than the single company can achieve alone.

They will have higher production levels, quickly running down the experience curve, with positive

effects on average cost per unit.

Another obvious disadvantage of the make option is the higher investment in fixed capital,

since in order to carry out the activity within the company, the need in capital can be high

and expenses include long term assets representing fixed costs, which are not related to production volumes.

Indeed, contrarily to making, the buying option is a way to turn fixed costs into variable

costs depending on the actual volumes the company supplies from the external market.

The make-option also requires costs linked to hierarchic coordination of the activity,

which becomes part of the company itself; it is important to underline, though, that

even outsourcing partially entails coordination costs, as the company changes its role from

executor to coordinator, thus controlling the supplier’s work.

Another problem linked to the make-option is the lack of motivation that could arise

in highly integrated companies, as human resources performing non-core activities can feel poorly

motivated, or low incentives to efficiency and effectiveness may be present when captive

market conditions arise, that is, a company or SBU is forced by corporate rules to acquire

as inputs the outputs of another SBU belonging to the same corporate portfolio.

The combined assessment of these pros and cons should drive a company’s strategic

decision favoring vertical integration or outsourcing.