Make or Buy? Study Examines When It Pays to Outsource

New Haven, Conn., January 28, 2008 — Conventional wisdom suggests that a firm's decision to make a critical input in house or buy it from an outside supplier is a matter of cost — a firm won't pay more to buy the input than it costs to make. But according to a new study, firms are often willing to pay a premium to outsource to a rival's supplier in an effort to undermine the rival's de facto alliance with that supplier.

“By outsourcing to a common supplier, a firm can prevent the supplier from favoring its rival through price incentives,” said Brian Mittendorf, associate professor of accounting at the Yale School of Management.

Mittendorf and colleagues Anil Arya of Ohio State University and David E.M . Sappington of the University of Florida analyzed the strategy surrounding a firm's make-or-buy decision. They found that when a firm buys an input from the same supplier as its rival, it reduces the supplier's vested interest in the rival's success. With both the firm and the rival as customers, the supplier's incentive to deliver the input to the rival on attractive terms is limited and thus the supplier will raise the price it charges the rival. The strategic benefit of getting both the input and the more favorable competitive conditions may make the firm willing to pay more to outsource production than its own cost of producing the input.

The authors found that the benefits of this strategy hold whether a firm outsources all of its input needs or chooses to make a portion in-house and outsource the remainder. They also found that a firm's make-or-buy decision can influence whether potential competitors will enter its industry. Buying the input causes suppliers to raise prices, which can deter potential rivals from entering the industry.

The strategic benefits of outsourcing could help explain the prevalence of outsourcing to powerful suppliers in lieu of finding alternative inputs that arises in many industries such as computer software and components.

“Although it might appear that some firms are outsourcing to common suppliers just because 'everyone is doing it,' in their industry, our analysis suggests that it can reflect a more calculated strategy,” said Mittendorf.

The paper “The Make-or-Buy Decision in the Presence of a Rival: Strategic Outsourcing to a Common Supplier” is available online.