Competitive supply The make or buy decision is a part of the more general problem of competitive supply. Making the product, or indeed performing the service oneself (in-house lawyers, etc.), is simply a case of self-supply. When compared with making in, external supply has two special features: a) costs are less likely to covary with internal costs, hence separate consideration is probably sufficient; b) in a competitive supply position, switching between suppliers will incur fewer transaction costs than changing between self-supply and external supply. The obvious implication of point (b) is that a firm should adopt a strategy of imping frothe chape or a soner tampine a. We now examine this policy in example 5. Example 5 Irlam Software retails packs of component X. It has identified two suppliers who have agreed to supply plain components to which Irlam adds its logo before selling. The price of component X varies between £3.5 and £5 in real terms for each supplier; there is an estimated 25 per cent chance that the price will be £3.5, £4.0, £4.5 and £5.0 at today's prices. The prices tend to vary according to each supplier's own production problems; they therefore move independently of each other. It is perfectly possible, for instance, that for a few months one firm may be selling at £5 and the other at £3.50; the prices will then change, there being no particular pattern. Calculate the expected cost and standard deviation of Component X, assuming that Irlam always switches its supplier to the cheaper of two. Compare this with the costs of a single supplier. The distribution of costs is rectangular (see Figure 9.4). The average price of a single supplier is 4.25, with a standard deviation of 0.56. If Irlam could switch between suppliers, then, assuming price independence, the probabilities of each price would be as follows: 3.5: 7.0 (0.25)^2=.4375 4.0: 5.0 (0.25)^2=.3125 4.5: 3.0 (0.25)^2= .1875 5.0: 1.0 (0.25)^2= .0625 (Hint: draw up a matrix of all the possible combinations, and note the cheapest price in each combination - the probability of each combination is 0.25%.) The distribution is now skewed (see Figure 9.5). The new average is 3.94 and the standard deviation is 0.46. As one might expect, the existence of competitive supply reduces the average cost and the spread of likely costs. Again we should stress that in practice the position is likely to be more complex. For instance, suppliers may not always have the capacity to supply and there may be other hidden costs, such as delays when suppliers are switched or reduced flexibility in the product from having more than one supplier (joint development is more difficult.