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Case study: A
American Apparel: Vertical Integration and the Make-Or-Buy Decision
The production of any good or service generally requires many activities. The process begins with the acquisition of raw materials and ends with the distribution and sale of a finished product or service; the process by which this happens is known as the vertical chain. Organizing the vertical chain is essential to business strategy, and the question that firms face when deciding how to do so is whether all of the activities ...view middle of the document...
The reasons a firm may choose to “make” instead of “buy” lie with the cost associated with buying. These include the costs associated with poor coordination between steps in the vertical chain, reluctance of partners to develop and share valuable information, and transaction costs.
A firm may choose to “make” if they do not wish to disclose private information such as product know-how, product design, or customer information to an outside vendor, and “making” will keep this information in-house. Costs from coordination problems arise in situations such as one party failing to meet production deadlines, delivery dates, or other performance targets. Contracts are often used in an effort to prevent coordination problems, however, the contracts themselves incur transaction costs such as the time and expense used in negotiating and enforcing contracts; or costs incurred from parties acting opportunistically and the firm trying to prevent that.
The decision for a firm to “buy” is made primarily because it is more efficient. The independent outsourcing partner from which a firm “buys” is known as a market firm. Market firms are often able to achieve lower unit costs than a firm producing only for their own consumption because they are often supplying for many buyers and are therefore able to exploit an economy of scale. In doing so, market firms are able to take advantage of the learning curve, accumulating more experience and know-how than a vertically integrated firm that does not have an economy of scale or does not specialize in a certain function.
Another reason for a firm to “buy” is the elimination of bureaucracy, or avoiding agency and influence costs. When managers and employees knowingly do not act in the best interest of their firm, they are said to be slacking. This reduces the firm’s profitability and incurs many different costs, including those from administrative controls designed to deter slacking, and lack of productivity. Influence costs are another type of cost incurred when a firm organizes transactions internally. When firms allocate financial and human resources across internal divisions and departments they create “internal capital markets.” If the internal capital is limited, when resources are allocated to one division, there are fewer resources to be allocated to others. Inevitably, managers try to influence this resource allocation. Influence costs can be incurred from the time wasted trying to influence the allocation, to bad decisions made as a result of influence.
In 2008, American Apparel purchased the assets of a fabric dyeing and finishing facility from U.S. Dyeing and Finishing, Inc., with whom they had contracted work from for approximately ten years. American Apparel assumed the lease of two buildings and purchased machinery and equipment related to fabric dyeing and finishing, including industrial dyers, washers, compressors, and boilers. Marty Bailey, Chief Manufacturing Officer of American Apparel acknowledged...