Relative Price Changes: Make or Buy A common problem faced by firms is whether they should 'make' or 'buy in' the goods and services they use. A manufacturing firm building engines, for instance, may decide to make as opposed to buy the electrical components. Some firms have their own legal department, others buy in the service. An important element of all such decisions is the need to establish the cost of each option. There are two aspects to this problem: (1) the cost of current resources and (2) prospective price levels. When making a component, or providing a service, a combination of internal and external resources will be used; some may be diverted from other activities, creating an opportunity cost, other resources may be 'free' in that they are surplus to current requirements. The concepts required to establish a relevant cost are discussed in section 4.5; in this section we examine the problem of incorporating future pricelevel changes in our decision. We cannot say that in future, other things being equal, we will choose the cheaper of the two options. The transaction costs of switching into and out of production and 'self-service' make such a policy impractical. Therefore, we have to take into account how the prices might vary in relation to each other as an integral part of the decision. This we can do by applying some of the techniques in chapter 3 - example 3 illustrates possible approaches. Example 3 Pendlebury Ltd is considering adding Product A to its range. It will sell for £10 per unit and have an expected cost of £6 if made by Pendlebury. An alternative is to import the item at a cost of £5.80. The cost of the bought-in alternative is expected to vary considerably, as it is subject to exchange rates which are not fixed. The variation of the two costs can be described as follows: The manager's reaction to risky choice may be described as decreasingly risk-averse, and is modelled by the equation U= 100 (logx/30,000), where x is the return and U is utility. It is expected that annual sales will be about 10,000 units. Will the manager prefer to make or buy Product A? Using the expected value criterion, it would be preferable to import Product A. However, if this option is selected, profits will vary more widely than if Product A is made in. We therefore need to confirm our selection by using the expected utility criterion. In this case, the expected utility from making in is greater than the importing alternative, indicating that it would be preferable to make Product A. Clearly, the greater variance of importing has offset slightly higher expected value. We should, however, be cautious in coming to this conclusion, as our calculations are only a partial view of the effect of price changes. The manager also has to take overall returns into consideration. For instance, when costs are high for making the product in example 3, what will be the level of other costs in Pendlebury Ltd? It is likely that they too will be high, assuming that there are common resources. Alternatively, when other costs are low, then Product A's costs should be low. In other words, we would expect there to be a positive covariance between the contribution from Product A and the contribution from other products. The effect of a positive covariance will be to increase the variance of the returns by more than the sum of the individual variances. Where X is the return on product A, and Y is the return on other products, as we have seen in chapter 2, Var (X+Y) =Var (X) + Var (Y) + 2 Cov (XY). By contrast, the imported substitute may well not have an especially strong covariance with other costs, as it is subject to the special influence of exchange rate fluctuations. In example 4 we continue with Pendlebury Ltd by looking at the general picture.