“Many firms have outsourced their payroll systems, while hardly any are “buying” R&D services. Explain why this is generally true, and why Monsanto followed a different strategy.”
Many firms outsource different functions of their business, such as payroll systems, IT services etc, where these are auxilliary functions to the firm i.e. they are functions which help the firm in day-to-day operations. I will here contend that it is possible to reduce a “make-or-buy” dilemma to a simple dichotomy between functions or competencies which are strictly auxilliary to a firm and others which constitute its very “core”.
The discipline of Transaction Cost Economics frames the dilemma as a range of trade-offs where the firm should make the “make-or-buy” decision based on the most cost effective alternative. By outsourcing a firm exposes itself to transaction costs such as the costs of negotiating and enforcing contracts with licencees. These costs must be evaluated with regards to “ownership costs” – the extra costs the firm incurs by performing the functions themselves. Such costs involve the extra bureaucracy needed and the draining of resources which could have been used more profitably elsewhere. Finally the firm must evaluate where the function can be produced most cheaply, in direct costs1. Summing up this simplefied problem will give a firm two sets of costs, the cheapest of which it should choose.
This presentation is problematic for functions such as R&D. The firm’s very existence is based- and dependent on its R;D. The firm is built around an idea where R;D is the function to develop the idea further or find related ideas which can be exploited. One can safely say that a firm will never outsource all R;D because that would to a great extent remove the whole justification for the firm. However a firm might want to outsource parts of R;D for different reasons. A whole set of problems arise if the firm wants to outsource this function. Chesbrough and Teece (1996) mention three questions which the firm must pose itself before making the decision. “Is the information necessary to be passed on codified2 or tacit”, “is the kind innovation sought autonomous or systemic to the firm” and “what is most important, incentives on the part of licencees or coordination and control over the R&D process”.
They regard R;D in this sense as any other function of the firm where questions of costs and convenience will decide the “make-or-buy” decision3. The problem is that R;D is a function which is highly interrelated with all other functions of the firm and may have strong complementarities with them. By outsourcing it the firm may risk that essential inputs to the R;D are lost, simply because it is removed from the firm itself (i.e. its natural environment). Another problem is of the very creative nature of R;D. Even though it may have all the characteristics that Chesbrough and Teece state, there is no guarantee that a decision to outsource is what is necessary for the creative process.
Monsanto made a strategic choice when it chose to move into downstream biotech in 1979. The outsourcing of parts of its R;D was therefore a special move for a firm in special circumstances. Time was of the essence, as put by Schneiderman: “Monsanto would not grow quickly enough to prove the utility of biotechnology if [the company] relied on in-house capacity alone” (Leonard-Barton ; Pisano, 1993). If the choice was to be implemented, a licencing agreement seemed like the best of the options available to the company. It realised that it had to be brought up to speed very quickly, were it to stand a chance. Monsanto, though it did rely on Genenetech for its move into biotech, did not have much to lose from the licencing agreement. It took advantage of a player in the market with competencies it did not have itself and Monsanto was the stronger part in the relationship. This latter point is a major qualification for the “rule” not to outsource R;D.
Arora and Gambardella (1990) have shown that in the biotech industry there are complementarities between different strategies of “external linkages”45. But the essential common denominator in all the examples is that they all add to the internal knowledge of the firm. With the exception of the initial move by Monsant into biotech, referred to above, where Monsanto was new to the game, it had a consistent policy of always having a solid base of in-house knowledge. As further shown by Arora and Gambardella (1990), a company will most likely experience complementarities when combining a strong internal knowledge base with various external linkages. It will better be able to evaluate the different opportunities for using some external moves and it will benefit from some of the very specialised competencies in the market.
Monsanto has pursued a strategy of using resources external to the firm with success. Some reasons why this has been possible are that the biotech industry is extremely innovation- and research intensive and specialised. Single firms do not have the resources or the capacity to specialise in the necessary fields which may be complementary. Further, the various steps in the sequential value chain are easily identifiable, reducing the need for intensive coordination as opposed to the IT industry (Phanish Puranam, 2003). Monsanto never removed R;D from the firm, but used external R;D as a complement to internal R;D. Genenetech was an expedient to entry.
Auxilliary functions of a firm can function on their own as they are not reliant on complementarities with other functions of the firm. The result of a set of calculations of transaction costs, ownership costs and production costs will determine whether to make or buy. R;D is more problematic because it is very different in nature from the other functions of the firm and because it most likely has strong complementarities with other parts of the firm in question.
In most instances this results in R;D being kept in-house. However, either because of general developments in the modern economy or the characteristics of the biotech- and related industries, both of which seem to tend towards increasing levels of specialisation, parts of R;D in some specialised industries is being performed via links external to the firm. Monsanto has pursued such a strategy with success, but with the very important qualification that is has always kept a very strong in-house knowledge based. This is necessary to ensure complementarities and degree of control.
A.Arora, A. Gambardella Complementarities and External Linkages: The Strategies of the Large Firms in Biotechnology, JIE 1990
H. Chesbrough and D. Teece When is virtual virtuous? Organizing for Innovation, Harvard Business Review, 1996
Leonard-Barton ; Pisano Monsanto’s March into Biotechnology (A) HBS Case Study, 1993
Louis Cabral Introduction to Industrial Organisation, Cambridge, Mass. : MIT Press, 2000
David Besanko, David Dranove, Mark Shanley
Economics of strategy, New York : Wiley, c2000.
1 By the market or by the firm
2 I.e. is it in the form of patents or industry standards.
3 I.e. if information is codified and easily can be passed on to the licencee, the innovation is of a stand-alone nature (autonomous) and incentives of outsourcing the innovation is risk free in terms of loss of private information., the firm should outsouce the function for that particular purpose
4 Agreements with other firms, agreements with universities, minority participation in smaller specialised firms and acquisitions of smaller specialised firms.
5 For purposes of R&D and innovationa