1.

1 Make-or-Buy Decision

PMN605 Strategic Project

Procurement

CRICOS No. 00213J

 Element Aim
• To develop an understanding of the make-or-buy
decision comprising theory and practice
(techniques and/or approaches) that guide and
frame the identification; assessment and
treatment of risk in terms of the likely influence
on ex post (post-contract) economic behavior
across the buyer and supplier/s, and in pursuance
of the highest aggregate net positive investment
in the project to improve project outcomes

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 Make-or-Buy Definition
• The decision whether to locate the activity within or
outside the firm is known as the make-or-buy decision
• More specifically, the make decision, or internalization,
is taken as the mode of governance in which the firm is
able to exert direct control over resources associated
with an activity and is wholly responsible for an activity
– As such this definition would include a contract of
employment and a wholly owned subsidiary
• Whereas, the buy decision, or externalization, comprises
all other modes of governance

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 Make-or-Buy implications
• Defining the firm
– its existence and evolution
– its boundaries
• Vertical boundaries delineating how far it undertakes
activities backwards into its supply chain and how far
forwards it undertakes activities delivered to other
firms downstream
• Horizontal boundaries delineating how much of an
activity the firm undertakes
– Both boundaries contribute to the scope and size of the firm

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 Theory of the Firm
• Make-or-buy decision is key part of theory of firm
– Firms exist as an alternative system to the market-price mechanism when it is more efficient
to produce in a non-market environment

• In simplified terms, the theory of the firm aims to answer these questions (
https://en.wikipedia.org/wiki/Theory_of_the_firm):

– Existence. Why do firms emerge? Why are not all transactions in the economy mediated
over the market?
– Boundaries. Why is the boundary between firms and the market located exactly there with
relation to size and output variety? Which transactions are performed internally and which
are negotiated on the market?
– Organization. Why are firms structured in such a specific way, for example as to hierarchy or
decentralization? What is the interplay of formal and informal relationships?
– Heterogeneity of firm actions/performances. What drives different actions and
performances of firms?
– Evidence. What tests are there for respective theories of the firm?

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 Firms and Markets
• Note: Theory of firm has many questions that
not resolved…already starting to look very
different from the make-or-buy decision
presented as a practitioner-ready “tool” or
“technique” in PMBOK
• Discussion point: Given that the market
comprises firms, then which came first the
firm or the market?

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 Internalization vs Externalization
• On surface, reasons look similar…
Reasons for internalizing activity
1. Improved control over:
knowledge/strategy/staff/quality
2. Cost savings through: less management
costs; economies of scale
3. Expertise and available resources
4. Flexibility
5. Confidentiality and security
Source: Bridge and Baldry (1996)
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Reasons for externalizing activity
1. Cost savings through: reduced
overheads (including management costs);
economies of scale
2. Specialist knowledge
3. Flexibility
4. Concentrate on core business
5. Reduce risk
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 Internalization vs Externalization
• Under surface, more complex!…

Source: Bridge, Tiong and Wang (2010)

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 Dominant theories of the firm
(relative strengths)

• Transaction Cost Economics, TCE (Oliver

Williamson, 2009 Nobel prize for economics)
– Focus on external transaction costs (hold-up)
• Transaction costs and property rights (Ronald
Coase , 1991 Nobel prize for economics)
– Focus on internal transaction costs (internal
organizational competence)
• Resource-Based Theory, RBT (Jay Barney et al.)
– Focus on competitive advantage (product and
production capability and/or competence)

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 Theoretical pluralism
• Inevitably any theory gives a partial account of cases
(depending on its assumptions)
• How can we harness the relative strengths of these
theories? In other words, how can we integrate these
theories?
– Answer: We can identify the conditions under which each
theory is superior to help explain (positive role of theory),
that then helps to guide decision-making (normative role of
these theories)
– Make sure we can explain first before we guide decision-
making!
• Reading: Bridge and Tisdell (2004)

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 Activity → Market Analysis
• Activity Analysis: A new infrastructure project is broken
down into activities using transaction costs logic, i.e. separate
activities are delineated where transaction costs occur across
the interface of technologically separable activities;
• Using market analysis or Structure-Conduct-Performance (SCP)
to understand market conditions surrounding an activity and as
a means to understanding when one of the key theories of the
firm is likely to be more powerful in explaining the firm’s make-
or-buy decision vis-à-vis the activity
• Let’s pause to briefly explain SCP before we see how we can use
this to integrate theories of the firm on the make-or-buy
decision

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 SCP
• The SCP approach developed by Bain in 1968 and Mason in
1939 is a general theoretical model from industrial organization
economics that can be used to classify an industry in terms of
its market (or extent of price competition)
• On the basis that the market represents stereotypical points in
a continuum of pricing possibilities, the match between the SCP
attributes and the industry’s market is far from exact
• Rather, the application of the SCP model allows some important
characteristics from an industry to be revealed and, in overall
terms, suggests that an industry may have a tendency towards a
particular kind of market (in terms of the level of price
competition)

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 SCP
Structure Conduct Performance Market (price competition)
 One firm  Use of market power  Above normal Monopoly
 Costly entry to set prices
 Small number of  Collusion  Above normal Oligopoly
competing firms
 Homogenous or
heterogeneous
products
 Costly entry and exit

 Large number of  Cost leadership  Above normal Monopolistic competition

competing firms  Product differentiation
 Heterogeneous
products
 Low cost entry and
exit

 Large number of  Price taking Perfect competition

competing firms
 Homogenous products
 Low cost entry and
exit

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 From Market to Sector Analysis
• When seeking to explain (as mean to guide)
the make-or-buy decision, then better to
analyse the sector and not market around the
activity
• For example, the “Construction Industry” can
be seen as a number of sectors (whose pricing
behaviour varies considerably) and not one
industry…

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 Construction Sectors
Market Structure Main Contractors Subcontractors
(SCP analysis)
Monopoly None None

Oligopoly Large main contractors Lifts, building automation

Monopolistic competition Some medium-sized contractors Mechanical Services (HVAC)

Perfect competition Many small and medium-sized Labour-based subcontracting

contractors

Source: de Valence (2003)

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 Example of Sector Analysis
• Extending de Valence sector analysis approach in a
building maintenance activity
– Reading: Bridge (2008)
• 3 steps to identify sectors of firms whose pricing
decisions affect each other
• Step 1: What different performance characteristics of
good/service are supplied by different firms?
• Step 2: When/how is good/service used by the buyer (occasions
for use)?
• Step 3: Where is good/service used by the buyer (geographical
spread)

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Integrating theories of
the firm on the make-
or-buy decision
Seeing the firm and market
firms as a relected capability
and competence spectrum
(Source: Bridge and Tisdell 2004;
Bridge 2008; Bridge 2015)

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Integrating theories of the firm on the make-
or-buy decision

Source: Bridge and Makovšek (2018)

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Integrating theories of the firm on the make-or-buy decision

Integrative framework of vertical integration

(Source: Bridge 2015 based on Bridge 2008 and Bridge and Tisdell 2004)

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 Assessing variables → Levels
• Same questions on each project specific activity
• Answered mindful of circumstances just prior to the
date that actual procurement decision made
• Questions written in past tense when the model is
applied in review mode (i.e. project ongoing or
completed (as per the following slides)
• Questions written in present tense when the model
applied in predictive mode i.e. when used to guide
the procurement of new project who’s design and
other downstream activities have not yet commenced

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Assessing variables → Levels

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Assessing variables → Levels

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Assessing variables → Levels

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Assessing variables → Levels

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Assessing variables → Levels

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Assessing variables → Levels

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Assessing variables → Levels

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Assessing variables → Levels

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 Assessing variables → Levels

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Assessing variables → Levels

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 Weaknesses in current practice on the make-or-buy decision
Maxim: Allocate risk to the party best able to manage
that risk
• This amounts to a capability and competence
perspective or RBT and Levels 1, 2, 7 & 8 in the
framework
• Not sensitive enough to fully account for internal
transaction costs or who can organize more
efficiently i.e. Levels 3 and 6 in the framework
• Practically overlooks the risk of negative
opportunistic behaviour or the risk of hold-up
• The above popular maxim on allocating risk to the
party best able to manage that risk is therefore
contributing to a void in decision-making that is
muting the role of risk analysis on the make-or-
buy decision and which in turn is creating a
tautology or non-science approach to
procurement Source: Bridge and Bianchi (2014)
• These are very serious charges!!!!!
• Discussion point: Any sign of this tautolgical issue in
PMBOK?

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Towards procurement reform including the
make-or-buy decision

Source: Bridge and Bianchi (2014)

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 Towards procurement reform including the make-or-buy decision
New procurement decision-making tool
• New tool incorporating the integrative framework of vertical integration and the entire ARC grant in
which it was developed and tested (objective #1) is cited and endorsed by the Productivity
Commission (page 461, Vol 2)
• Successfully trialled in major hospital and major road in Australia (funded by Infrastructure Australia
and Austroads respectively) with the User Manual to be published December 2020
• Readings
• Teo, Bridge and Jefferies (2010); Teo and Bridge (2017); Bridge and Bianchi (2014) pages 11-23; Austroads (2020)

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 Towards procurement reform including the make-or-buy decision

New procurement decision-making tool

• Next, OECD want to adopt tool and apply across the world (Chapter 7, “Conclusion: Way Forward” pages 107-
112 in recent report of in-depth study into infrastructure, launched in Paris, 22 June 2018)
• Full-report available at: https://www.itf-oecd.org/private-investment-transport-infrastructure-uncertainty
• Presentation of the model at the launch in Paris 2018…

• The tool will also be applied to Australian schools (both government finance d schools and privately
financed schools) in a current ARC grant (see Activity #6 at https://research.qut.edu.au/arcvio/)

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 Towards procurement reform including the make-or-buy decision
We covered an outline of Steps 1
and 3

More on this new tool in later

weeks…

• Steps 2 and 4 (Bundling Week 4)

• Step 5 (Nature of the Exchange
Relationship in Week 5)
• Empirical testing of the model
using competition as proxy of
value-for-money (Tenedering
Week 8)

Source: Bridge/Austroads (2020)

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 Summary (mainly a priori)
• Understanding the way make-or-buy decision
influences economic behavior and, in turn, how this
influences project outcomes
– Through lens of inefficient make-or-buy decisions…
• Making a Level 8 activity or buying a Level 1 activity
– Economic behavior
» Could not deliver scope/fit for purpose in short term and so should
really be not applicable
– Outcomes
» Disaster if attempted and start again and buy Level 8 activity from
market firm
» If activity is on critical path, then even worse than disaster!

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 Summary (mainly a priori)
• Understanding the way make-or-buy decision influences
economic behavior and, in turn, how this influences project
outcomes
– Through lens of inefficient make-or-buy decisions…
• Making a Level 7 activity or buying a Level 2 activity
– Economic behavior
» Could deliver scope/fit for purpose but cannot generate critical economies of
scale to justify investments
– Outcomes
» Will not recoup investment (across projects)
» At project level
• Less likely to yield innovations as Level 7 by market firm
• Cost more and/or take longer (absolute terms)
• If activity is on critical path, then inferior outcomes made more inferior

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 Summary (mainly a priori)
• Understanding the way make-or-buy decision influences
economic behavior and, in turn, how this influences project
outcomes
– Through lens of inefficient make-or-buy decisions…
• Making a Level 6 activity or buying a Level 3 activity
– Economic behavior
» Could deliver scope/fit for purpose but cannot generate continuity of workload
– Outcomes
» Investments and innovations less of issue here
» At project level
• Cost more and/or take longer (absolute terms)
• If activity is on critical path, then inferior outcomes made more inferior

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 Summary (mainly a priori)
• Understanding the way make-or-buy decision influences
economic behavior and, in turn, how this influences project
outcomes
– Through lens of inefficient make-or-buy decisions…
• Making a Level 5 activity
– Economic behavior
» Could deliver scope/fit for purpose but insufficient workload to justify
internalization
– Outcomes
» Investments and innovations important (given high level of asset specificity)
but potential for innovation across make-or-buy similar and so this not the
issue
» At project level
• Cost more (absolute terms)

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 Summary (mainly a priori)
• Understanding the way make-or-buy decision influences economic
behavior and, in turn, how this influences project outcomes
– Through lens of inefficient make-or-buy decisions…
• Buying a Level 4 activity
– Economic behavior
» Could deliver scope/fit for purpose but opportunity cost and forgoing superior workload
» Risk of negative opportunistic or hold-up (on quality and/or time and/or costs in absolute
terms) if downstream procurement decisions sub-optimal
– Outcomes
» Investments and innovations important (given high level of asset specificity) but potential
for innovation across make-or-buy similar and so this not the issue
» At project level
• Opportunity costs and potential for hold-up resulting in reduced quality and/or
increase time and/or costs (absolute terms)
• If activity is on critical path, then these inferior outcomes worsened

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 Tips on Key Issue 1 (again a priori)

– Aim
• To investigate and develop a critical evaluation of the
relative importance of each of the elements of
procurement (Topics #1 to 6) on project outcomes vis-
à-vis your case study (chosen buyer and sector/project)
– Including how much this may vary significantly across
outcomes and sectors/projects

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Tips on Key Issue 1 (again a priori)
• Let’s start with considering the null hypothesis (no
significant differences i.e. all decisions have the
same effect on all outcomes)

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 Tips on Key Issue 1 (again a priori)
• Then each week (from Week 4) consider whether there are significance
differences in the elements studied to date in terms of their relative
importance on our 6 outcomes in your case study and which allows you to
rank the elements; For example, based on significant differences, one possible
alternative hypothesis is as follows (where 1 = most important/biggest effect
on outcomes)

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