TRANSACTION COST ANALYSIS: THE MAKE-OR-BUY DECISION

The economic field of transaction cost analysis looks at make-or-buy decisions. The
make-or-buy decision considers whether a transaction is more economically performed
internally (make) or through external sources (buy). We all analyze transaction
costs many times a day, often without even considering what we are doing.
Sometimes the decision is obvious, sometimes not. Did you make your lunch today
or buy it at a convenient restaurant? If you made your lunch, did you grow your
own tomatoes? Bake your own bread? Make your own butter? You probably bought
your lunch or bought the components of your “homemade” lunch, but it has not
always been that way. Turn back the clock a few generations in the U.S., to the
agrarian society. In that age, there were many more make than buy decisions. Living
then was not, generally, as easy as now, but personal independence was much greater,
because there was less reliance on external supplies for basic necessities. Observe
today what happens in large cities if a power outage extends more than 2 days
because of weather or system failure. Communication is limited or curtailed, pumps
do not work (limiting water and fuel supplies), and food supplies begin to dwindle.
Without electric power, many of our “buy” decisions are interrupted. The interdependence
of modern civilization begins to fray at the edges.

Or travel to the third world today and see people taking care of their own
fundamental needs. Rural economies in most of the world provide a subsistencelevel
existence; people live off the land. Their meager existence is balanced by
considerable independence for the fundamental necessities of life. Third-world living
conditions can consist of a few animals for milk, meat, and fabric; a plot of land
for food; water from a well or stream; and a shelter constructed of the most basic
materials. The lack of commerce (fewer transactions) due to minimal currency
availability and inherent lack of corporate employment shifts the make-or-buy decision
to the make side.

The make-or-buy decision determines our transportation (ride an animal, bike,
bus, car, plane — or walk), our clothes (make material, sew, buy at store), our
entertainment (sit and talk, sing, play an instrument, listen to others play, listen to
radio, watch TV, browse the Internet), and our health (exercise, eat healthy food, sleep regularly, take pills, have operations). Economic standing, availability of items,
availability of currency, needs vs. wants, and many more considerations play a role
in our personal decisions whether to make or buy. Every organization (individual,
family, firm, or community) decides to make or buy numerous times for every
endeavor in which it engages. The organization’s discernment of value in these
choices often determines its long-term success. A thorough understanding of the
mission, purpose, and values of the organization provides a guide to the myriad of
make-or-buy decisions.