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Answering the Department of Defense Make or Buy Question

Abstract

This article reviews the make or buy decision in the Department of the Navy through the

theorical lens of Transition Cost Economics (TCE), and actual transactions costs expended at

Naval Sea Systems Command (NAVSEA). The article highlights the TCE components prevalent

in the DoD; idiosyncratic requirements, asset specificity, uncertainty of future requirements,

frequency of contracting and actor’s opportunism. The literature review explains how these

components lead to vertical integration in other professional industries. Industries where profit

and loss are a factor and, typically, the primary decision metric considered. The result of this

review supports the position that the Department of Defense (DoD) should increase civilian

staffing authorization levels and vertically integrate professional service support contractors. The

generalizability of this review and its findings are presented. The final position of the article is,

the individual services and collective DoD should vertically integrate professional service

support contractors and invest the cost avoidance into other defense priorities.

Introduction

In Fiscal Year 2019 the Department of Defenses’ annual budget was $686 billion dollars,

with $380 billion of those dollars placed on contracts to non-government agencies/firms (GAO,

2021). During the planning, programming, budgeting, and execution (PPBE) of those dollars the

inevitable question of, should we make this or buy it? arises. To address that question, I will

narrow the focus of research from all of the Department of Defense to the Department of the

Navy and from all contracting spending to service contract spending; which was $44.5 billion
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dollars, half of total contract spending, in Fiscal Year 2019 (GAO, 2021). I approach this

research through the theorical lens of Transaction Cost Theory, or Transaction Cost Economics

(TCE) by reviewing extant literature, both theoretical and empirical, I apply the generalizability

of the findings to answer the Department of the Navy service contract make or buy question.

The paper will first provide an in-depth literature review on the TCE, beginning with the

origins of the theory, followed by empirical testing of the theory, and applicability of the theory

in a government and/or aerospace setting and finally the applicability to utilize TCE in

determining weather to vertically integrate (make) or contract (buy). Following the literature

review I will provide a summary of salient points relating to the research question, the

applicability of extant research to the research question, implications of the findings, limitations

of the research and a summary and course of action to answer the research question, should the

Navy make or buy professional services?

Literature Review

Fundamentals of Transaction Cost Theory

The fundamentals underpinning Transaction Cost Theory began with Ronald Coase, in

his paper the Nature of the Firm (Coase, 1937). Coase, an economist, theorized on why a firm

comes to exist. At the time of his writing the price mechanism was a widely held economic

theory stating that self-employed individuals would create contracts with each other with each

other based on the bid price (the price the buyer is willing to pay) and ask price (price the

supplier will accept) for the requirement. Coase posited that the “main reason why it is profitable

to establish a firm would seem to be that there is a cost of using the price mechanism” (Coase,
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1937, p. 390). Coase described the costs of using the price mechanism as the cost of discovering

what the relevant prices are, the cost of negotiating the final price and the cost of creating a

separate contract for each transaction. Coase also postulated that the contracts between self-

employed entrepreneurs should only state the limitations to the supplier entrepreneur, so they can

direct and control factors of production. It is important to note that in this early writing and

development of the theory Coase differentiates between service labor and commodities, the latter

is also known as end items in the DoD.

“A firm is likely therefore to emerge in those cases where a very short-term contract

would be unsatisfactory. It is obviously of more importance in the case of services-

labour-than it is in the case of buying of commodities, the main items can be stated in

advance and the details which will be decided later will be of minor significance.”

(Coase, 1937, p. 392)

Coase makes many theoretical contributions in this seminal paper, one that is of

importance for our research question is the notion that a firm and or organization will grow until

the cost of organizing a transaction within the firm becomes equal to the cost of carrying out the

same transaction. (Coase, 1937) Meaning, that firms will organize and exist to lower the costs of

acquiring labor and commodities by internalizing production up to the point that is more cost

effective to contract the requirement out in the market.

Coase can be thought of as the early architect of TCE, sketching out the rough design and

Williamson as the skilled craftsmen that built out the initial theory into an in-depth complete

school of economic practice, that today is still widely in use. Williamson, to date, has written

almost 100 papers and five books on the topic of Transaction Cost Theory. Williamson shapes

the theory from the notion of a simple mathematical calculation, if the costs to contract are
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greater than the costs to internalize the requirement, that the firm will make the requirement; to

one of many constituent elements ranging from the concept of a rationally bounded economic

agent to the degree of clarity and certainty in the firms understanding of the contract requirement

over time and the how complex the requirement is. For purposes of this review, we will consider

factors relating to Navy service contracting such as; idiosyncratic requirements, asset specificity,

uncertainty of future requirement, frequency of the contract and actor’s opportunism.

The notion of idiosyncratic investments in human capital is presented in Williamson’s

paper titled Transaction-cost Economics: The Governance of Contractual relations (Williamson,

1979).

“Ordinarily, however, there is more to idiosyncratic exchange than specialized physical

capital. Human-capital investments that are transaction specific commonly occur as well.

Specialized training and learning-by-doing economies in production operations are

illustrations. Except when these investments are transferable to alternative suppliers at

low cost, which is rare, the benefits of the set-up costs can be realized only so long as the

relationship between the buyer and seller of the intermediate product is maintained.

(Williamson, 1979. P. 240)

Idiosyncratic requirements can be defined as requirements that are unique in nature.

Williamson clearly articulates the challenges a manager has in deciding to contract for a skill set

that is specialized and created, in part by, learning by doing when in doing so will only be a

benefit to the buyer if the relationship with the seller is maintained. Williamson also presents the

concept of asset specificity in his paper Comparative Economic Organization: The Analysis of

Discrete Structural Alternatives (Williamson, 1991), where he decomposes asset specificity into

six constituent parts; site specificity, physical asset specificity, human-asset specificity, brand
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name capital, dedicated assets, and temporal specificity. He posited that asset specificity would

create a bilateral dependency between consumer and supplier. Williamson also cautions that

asset specificity increases governance costs of the transaction, and that added specificity should

only be used when the cost of additional transaction governance outweighs the cost of production

cost-savings. Williamson then defines and describes the issue of requirements uncertainty in his

book titled The Economic Institutions of Capitalism,

“Whenever investments are idiosyncratic in nontrivial degree, increasing the degree of

uncertainty makes it more imperative that the parties devise a machinery to "work things

out" since contractual gaps will be larger and the occasions for sequential adaptations will

increase in number and importance as the degree of uncertainty increases.” (Williamson,

1985, p. 60).

Williamson elaborates on this comment and provides some explanation of why

uncertainty and may arise; in part it may be driven by the actors bounded rationality, meaning

the parties to the contract negotiation only know the information they have at the time of the

negotiation, and that all future issues or challenges can not possibly be known. In his paper titled

Transaction Cost Economics: The Natural Progression (Williamson, 2010) Williamson further

overlays bounded rationality on contract creation stating that due to bounded rationality “all

complex contracts are incomplete” (Williamson, 2010, p. 677). Williamson nests the frequency

of the transaction along with the complexity of the investment; nonspecific, mixed, and

idiosyncratic (Williamson, 1979). Navy Service contracting fits into Williamson’s model

(Appendix A) under reoccurring idiosyncratic transactions; Williamson then applies his model to

contract governance models/contract types. While current Navy Service contracting aligns to

bilateral governance: obligational Contracting defined as

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“Highly idiosyncratic transactions are ones where the human and physical assets required

for production are extensively specialized, so there are no obvious scale economies to be

realized through interfirm trading that the buyer (or seller) is unable to realize himself

(through vertical integration)” (Williamson, 1979, p. 250).

Another area of fit, for Navy service contracting, is under the classification of Unified

Governance: Internal Organization. Williamson describes the organizational setting for this type

of governance structure to be utilized in.

“Incentives for trading weaken as transactions become progressively more idiosyncratic.

The reason is that, as the specialized human and physical assets become more specialized

to a single use, and hence less transferable to other uses, economies of scale can be as

fully realized by the buyer as by an outside supplier. The choice of organizing mode then

turns on which mode has superior properties.” (Williamson, 1979, p. 252)

“Vertical integration will invariably appear in these circumstances” (Williamson, 1979, p.

253). The final area of Williams work I will review for this paper is the concept of actor

opportunism which Williamson defines as “self-interest seeking with guile. This includes but is

scarcely limited to more blatant forms, such as lying, stealing, and cheating” (Williamson, 1985,

p. 47). Williamson notes that “opportunism is especially important for economic activity that

involves transaction-specific investments in human capital” (Williamson, 1979, p. 234). The

fundamental issue Williamson highlights is that individuals will seek an advantage when there is

an opportunity to do so, in the context of our research question advantage would be financial

gain. Should a party to the transaction discover opportunism and unjustified financial gain at the

expense of the other party, the issue would need to be addressed in a formal contract legal
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setting. Williamson perceptively points out that in situations where the contract is not with the

market but instead vertically integrated within the organization, that opportunism can be

addressed throughout the organizational hierarchy, calling it “its own court of ultimate appeal”

(Williamson, 1979, p. 234). This would certainly add efficiency in addressing opportunism and

allow the organization to adopt standard practices for addressing this behavior.

Transaction Cost Theory and Vertical Integration

Vertical integration is the decision of an organization to make something internally rather

than contract for it in the marketplace. TCE has long been a benchmark assessment aiding firms

in the decision to choose what products and services it should vertically integrate vice what

should stay outside the original structure. While scholars and practitioners may use TCE to

develop organizational structure and strategy, the following papers reviewed empirically test

TCE as an economic efficiency benchmark, as Coase originally intended.

In Asset Specificity and the Structure of Vertical Relationships: Empirical Evidence, Paul

Joskow empirically tests one of Williamson’s early theories regarding relationship specific

investments; specifically Joskow tested the idea that site specificity, one component of asset

specificity, lead to a relationship specific investment thus the cost of the initial investment would

be worth less in the market place then on the contract for its original intended use, and overtime

the specificity would tend to transform into the acquiring agency’s vertical integration of the

requirement. Joskow reviewed the contract duration and vertical integration methods of electric

coal burning power plants located at the “mouth” of a coal mine. His findings supported

Williamson’s theory, electric power plants located near a mine “mouth”, site specificity, created

a bilateral dependance between the coal provider and electric utility power plant, thus the electric
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utility plant created subsidiaries and vertically integrated the souring of coal into their

organization.

Klein, Crawford and Alchain also build on Coase and Williamsons work, in their paper

Vertical Integration, Appropriable Rents, and the Competitive Contracting Process. Their

primary theoretical position is that “as assets become more specific and more appropriable quasi

rents are created (and therefore the possible gain from opportunistic behavior increases), the

costs of contracting will generally increase more than the costs of vertical integration” (Klein et

al., 1978, p. 298). The authors are presenting the notion that the more specific a requirement

becomes the more opportunity there is for opportunistic behavior, again defined by Williamson

as “lying, stealing, and cheating”. (Williamson, 1985, p. 47) given this potential a contract would

have to be so well written and address all possible scenarios that could arise during performance,

which is not possible due to bounded rationality, that by the time the contract was written,

implemented, managed/governed; it would have been more cost efficient, and less risky, to

vertically integrate the requirement. The authors continue in the paper to describe subtle

opportunistic behavior, specifically in the forms of less efficient operation, this increased

uncertainty of quality also adds legitimacy to the decision to vertical integrate. The authors were

able to empirically test their and validate their theory by utilizing data and information relating to

the 1926 merger of Fisher Body with General Motors. Important to note as the relationship from

the two separate companies evolved and contracts were negotiated back at forth over time,

General Motors entered into a cost-plus fixed fee contract with Fisher Body; their cost of

production plus 17.6 cents. Ultimately a merger was executed in order for General Motors to

have more control, or fiat, over the automobile body parts production process.
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Grossman and Heart build upon the work of Coase, Williamson, Klein, Crawford and

Alchain by creating a mathematical model to empirically test and explain the case for vertical

integration by a firm, the model is primarily centered around the idea that the acquiring firm

desires control of providing firm level assets; the results of their study indicate that when it is

too expensive/inefficient for one party to specify a long list of the particular rights it desires over

another party's assets, then it may be optimal for the first party to purchase all rights except those

specifically mentioned in the contract”(Grossman & Heart, 1986, p. 269) Grossman and Heart

clearly differentiate ownership and vertical integration, as they relate to procurement of rights,

with ownership defined as procuring rights of control and vertical integration the purchase of

assets to acquire rights of control.

Anderson and Schmittlein build upon the previous work of Williamson, Klein, Crawford

and Alchain by adding depth and empirical testing to the concept of specialized relationship and

asset specificity as related to human assets and the concept of uncertainty, introduced by

Williamson, but in the context of evaluating employee performance. To test their theory

Anderson and Schmittlein analyzed survey data from the electronics component industry in

which they assess managers perception of the complexity of a salespersons job, operationalized

by six attributes of the firm; complexity of the firm, complexity of the product, confidential

information, nature of the customer, importance of key accounts and importance of customer

loyalty. Their hypothesis was the more complex the job is perceived to be by managers the

greater the likelihood direct employees will be utilized to sell the components vice manufacturer

representatives. Their findings supported their hypothesis and the notion that uncertainty, in this

case “how difficult it is to evaluate individual performance” (Anderson & Schmittlein, 1984, p.
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393) leads to vertical integration/utilization of a direct sales force, as well as the theory that

transaction-specific assets are a significant determinant of vertical integration.

Transaction Cost Theory in Government Setting

The articles reviewed from Coase and Williamson were theoretical in nature and

did not address how TCE would fair in a government setting which, unlike firms in the

marketplace, does not consider profit and loss reporting, is not publicly traded, or privately

owned. That said, government officials do have an obligation to be good stewards of taxpayer’s

dollars and meet on time delivery of goods and services to its citizens. It would seem the

commonality between firms in the marketplace and the government are efficient operations and

meeting needs of customers. In fact, Williamson (1985) states that defense contracting was not a

counterexample of the transaction cost model.

Masten empirically tests the theories of TCE and the applicability to vertical integrations

in the defense-related production industry (Masten, 1984). He notes the key characteristics of the

work such as high asset specificity, uncertainty of long-term requirements and previous

empirical studies; to form his hypothesis that vertical integration would be more apparent in the

aerospace component industry. The results of his study are very similar to empirical tests in other

industries, with some important distinctions. Masten found that as the complexity of an item

increased so would the predisposition to make the component inter-firm rather than buy it, he

also found that asset specificity/complexity drove a managers perceived need to control the

production of the component; “the perception of a need for control arose primarily in those cases

in which the market or the courts were least likely to regulate transactions effectively, again

when production was highly specialized and complex” (Masten, 1984, p. 412). He finds that due

to potential future issues with contract governance and enforcement, stemming from the
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specificity/complexity of the component design defense-related firms forgo buying to make these

types of components," Moreover, as expected, the hazards of incomplete contracts in complex

environments appear to be much greater when specialized designs are involved, increasing the

likelihood of internalization from 31 percent to 92 percent” (Masten, 1984, p. 412).

Alder, Scherer, Barton and Katerber empirically test the TCE elements of “asset

specificity, uncertainty and contract incompleteness” (Alder et al., 1998, p. 185) to predict the

contract utilized by the government in procurement of a service or item. To test their

hypothesis(s) the authors conducting a longitudinal study by reviewing 4,581 closed contracts

awarded from the United States Air Force Material Command (AFMC), as their first source of

data and annual sales data of defense contractors from Moody’s Industrial Manual, for their

second source of data; for the periods of 1974-1993. The authors grouped contracts by the three

types; Firm-fixed Price (FFP), incentives, and Cost-plus Fixed Fee (CPFF) then operationalized

the elements they set out to review. For example, asset specificity was operationalized by taking

the total number of estimated FTE hours, from the provider, and dividing those hours by the total

cost of the contract resulting in a per hour contract cost; those contracts with a high per hour cost

indicated high human asset specificity. The findings of their study support their hypothesis that

TCE elements influence contract type, a significant finding was that uncertainty had a profound

impact on what type of contract was utilized.

“Contract requirements are difficult to categorize or develop, phrases like ‘Not-to-exceed

or “Not Separately Priced” are included in the contract. Requirements like this indicate an

open-ended contract form which the CPFF type is best suited for meeting governance

needs. Work objectives typically employed in CPFF contracts are to design, develop, and
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test new projects, products or services which lead to future contract changes” (Alder et

al., 1998, p. 196).

The authors also make the point that in CPFF type buyer risk is high, and the managers

on the buyers (government) act as a mentor to the seller’s firm; where in FFP the seller assumes

all the risk. Additionally, the authors note that CPFF contracts have the highest asset specificity

out of all the contract types.

Literature Summary

The literature review began with seminal theoretical contributions to economic theory, by

way of the development of TCE. The key components of TCE in its early stages were total costs

of a transaction; planning, deciding/contracting, changing plans, resolving disputes, and after-

sale governance, compared to the cost of producing the requirement inter-firm. As the theory

developed so did other areas of consideration such as idiosyncratic requirements, asset

specificity, uncertainty of future requirement, frequency of the contract and actor’s opportunism

(Williamson, 1979). Academia then empirically tested elements TCE in several industrial

settings such as, coal mines, electronic component sales, automobile manufacturing. Finally, the

literature review brough forward empirical studies from the defense and aerospace industry

which were empirically tested and showed TCE elements exist and are part of decision making

in the Department of Defense.

Implications

Naval Sea Systems Command (NAVSEA) is the largest system command (SYSCOM) in

the U.S. Navy, both in terms of total obligation authority and personnel. NAVSEA is comprised

of approximately eighty thousand civilian and military personnel, with a fiscal year 2019 total
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obligation authority (TOA) of $55.3 billion (Appendix B). To accomplish its mission, NAVSEA

has several subordinate organizations aligned in a traditional organizational hierarchy. One group

of organizations aligned to NAVSEA are the Naval Surface and Undersea Warfare Centers

(NSWC/NUWC), which are comprised of ten individual activities/commands each with a

specialization such as; naval architecture, electronic warfare, propulsion, mine warfare, etcetera.

These Warfare Centers are operated similar to a civilian business, insomuch as they charge a fee

for service. Although there is one significant distinction, the intent of the organization is to,

every year, balance their financial account to zero by neither making nor losing money. These

organizations are structured similarly to businesses with indirect support, support codes such as

human resources, contracts, financial, and leadership staff. It is important to note these

organizations are not the typical government agency funded by direct appropriations, rather they

operate on a working capital fund, primarily funded by providing services to appropriated

customers (fee for service).

In 2018 NAVSEA published a directive that delegated all contracted service support

work to NSWC and NUWC, the intent of this directive was to alleviate workload and operational

tempo for the headquarters contracting officer(s) so they could focus on major defense asset

procurement such as; submarines, aircraft carriers, torpedoes, etcetera. Since NSWC and NUWC

perform work on a fee for service bases all service contracts executed by their contracting

components are subject to an administrative fee, also knows as an acquisition service cost center

(ASCS) fee. These fees are a percentage of the total contract value and vary based on which

NSWC or NUWC is performing the contracting action. For example, in 2019 NSWC Indian

Head, charged a six percent ASCS fee for execution of all service contracts; meaning if
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NAVSEA HQ sent NSWC Indianhead a $100,000 service contract the total cost to award the

work would be $106,000.

This new structure of doing business for service contracts, which are high in idiosyncratic

requirements, asset specificity, uncertainty, create a bilateral dependance, and are typically CPFF

should be reconsidered through the lens of TCE to better understand if NAVSEA should

continue to contract/buy this service or vertically integrate/make them.

During my tenure as the Division Head for NAVSEA 00I, the information technology

department, I oversaw the award of a $125,000,000 information technology service contract

(these costs were labor only, other direct costs/material are excluded from this discussion); the

following transaction costs, derived from Coase’s original theory, of that acquisition are

provided in Figure 1, anecdotally for consideration.

Figure 1 Here

Contract planning can be described as market research, acquisition strategy, government

cost estimation, requirements writing, and industry day/engagement. Proposal review includes

Source Selection Evaluation Board (SSEB), Source Selection Advisory Council (SSAC) and

Selection Authority (SA) time as well as legal and contracts review. Contract award represents

the ASCS fee. Contract modification and dispute resolution include Contractor Office

Representative (COR) administrative time as well as Technical Point of Contract (TPOC)

administrative time, resulting in a P00 MOD; important to note under the NAVSEA service

contracting process modifications that do not add funding to contracts are at no cost to the

customer. Contract governance represents one mid-level government COR. Note that COR,
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TPOC, SSEB and SSAC rates are based on GS-14 and GS-15 average hourly rates, while SA and

Legal rates are based on Senior Executive Service (SES) average hourly rates.

To further explore the make or buy decision in respect to services we must

consider the additional areas of TCE presented by Williamson and empirically tested by others

such as; idiosyncratic requirements, asset specificity, uncertainty of future requirements,

frequency of the contract and actor’s opportunism. When considering idiosyncratic requirements,

one must consider a problem that permeates all of the DoD, there is not one common tool be it it

financial, logistics, or engineering in nature commonly used across the Department. Navy service

contracts often list experience with Navy specific systems as a requirement in many labor

categories; hence we can say yes there are idiosyncratic requirements, ones that can only be

achieved through learning-by-doing, in Navy service contracts. Asset specificity, as it related to

human assets is also prevalent in Navy service contracts; Anderson and Schmittlein (1984)

showed that asset specificity, as challenges with evaluating individual performance created

uncertainty and governance costs which lead to vertical integration; certainly, evaluating

individual contractor’s performance on Navy service contracts aligns tightly with Anderson and

Schmittlein work regarding sales representatives or direct employees. Bounded rationality and

the dynamic nature of defense initiatives limit managers ability to contract for all possible

outcomes and/or requirements, so we can say yes uncertainty of future requirements is present in

Navy service contracting. For example, when the NAVSEA 00I contract was awarded, there was

no mention of Microsoft Teams, Cloud Computing, pandemic contingency planning or cost for

any of these “pop-up” requirements. This uncertainty again is better mitigated through vertical

integration where the existing hierarchy can address these instances immediately and efficiently

as they arise. NAVSEA frequently contracts for services, with no intention to change that
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staffing/manpower approach in the future, perhaps due to Congressional limits on force size and

structure. Nevertheless, the frequency of support service contracts, one major contract every five

years, places NAVSEA’s service contracts in Williamsons model (Appendix A) and shows a

case for vertical integration. Actors’ opportunism may be one of the most discussed topics inside

program offices that contract for professional services, while labor categories are typically

specific in personnel requirements the language inside the contract specifying what the

contractors are supposed to deliver, is often vague and ambiguous this is especially true when

CPFF type contracts are used, and as noted the previous work by Alder et al (1998) CPFF is used

when human asset specificity is high. This places all the risk on managers inside the program

office vice the contractor thus, we can say yes actor’s opportunism is present in Navy service

contracting.

Limitations

This review is not without is limitations, the first is generalizing the entire Navy service

contracting approach based off NAVSEA’s approach. Thought it is important to note, NAVSEA

does represent the majority of Navy acquisition commands thus the implications of this

limitation may be minimal. Additional limitations are the use of anecdotal rates to calculate

transaction costs, while I have an etic perspective of NAVSEA’s contracting transactions costs

my experience may have been a unique one, perhaps given the contract dollar value or some

other variable not common across the command. Additionally, the literature review while in

depth was not completely comprehensive, other research may exist that runs contrary to the

literature I have presented here.

Conclusion
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When considering the make of buy decision in the Department of the Navy through the

theorical lens of TCE; vertically integrating professional services is in the best interest of the

Department. The transaction costs alone, for the NAVSEA 00I procurement total over $3.7

million, for five years of IT support contractors this, of course, does not consider that the

contract type is CPFF, and in the case of General Motors and Fisher Body CPFF, in part, lead to

General Motors acquiring Fisher Body. The total transaction cost of $3.7 million divided by the

total requirement cost equates to .03 cents of transaction cost for every dollar of requirement.

While initially this number may seem so low it could be ignored, when compared to the Navy’s

2019 service contracting spend of $44.5 billion the transaction cost of would total over $1.1

billion and when further extrapolated to the entire DoD’s 2019 service contract spend the

transaction costs would be $4.7 billion. The return to the taxpayer or reinvestment into new

defense technology make the decision to make/vertically integrate all professional services a

commonsensical one.

Fully burdened government salaries for professional services are becoming closely

aligned with fully burdened industry rates; by vertically integrating the contract employees the

government can also avoid the contractors service fee. Finally, I have demonstrated that the TCE

components of idiosyncratic requirements, asset specificity, uncertainty of future requirements,

frequency of contracting and actor’s opportunism lead to vertical integration is other professional

industries, where profit and loss are a factor. There is no reason the Department of the Navy can

not integrate the employees, at a significant cost savings. Congress should consider the vale to

the taxpayer from vertical integration and increase Navy end strength to make the service

employees rather than buy them.

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