Question

6.         Evaluate the following:

a.         "The major advantage to outsourcing is that it reduces the company's capital costs, freeing the company to use scarce capital for other purposes." (8 points)

b.         A manufacturer of pencils contemplates backward integration into the production of rape seed oil, a key ingredient in manufacturing rubber-like material (called fractice) that forms the eraser. Rape seed oil is traded in world commodity markets and its price fluctuates as supply and demand conditions change. The argument that has been made in favor of vertical integration is this: "Pencil production is very utilization sensitive - i.e., a plant that operates at full capacity can produce pencils at a much lower cost per unit than a plant that operates at less than full capacity. Owning our own source of supply of rape seed oil insulates us from short run supply and demand imbalances and therefore will give us a competitive advantage over rival products." Do you agree or disagree with this argument? Explain. (8 points)

Answer 1

a)Outsourcing means to contract out.It refers to the practice of getting certain jobs performed outside the company.The purpose is to reduce cost as well as increase the efficiency by hiring another company to manage the operations which were earlier done by employees within the company.An important resaon to outsource involves freeing the internal resources ie capital and thus using the resources for other purposes.

. Outsourcing may convert fixed cost into variable cost and will release capital fot investment so that businesses can avoid large expenditure during the early stages  of their evolution.Thus business expenses will be lowered.This will attract investors since by ourtsourcing the company will be able to put a large amount of capital directly into the activities which will produce revenue.

b)I disagree with this argument . This argument is incorrect because initially it is said that rapeseed oil do not have a steady supply and demand and so growing it yourself will not help as the person growing on his own will face the same problem of unsteady supply and demand.

If the market for rape seed oil was not liquid and not efficient ,increasing supply would have been a proper reason  for vertical integration. But on world commodity exchanges, rapeseed oil is traded freely .So vertical integration will have no economic benefits . If transfer prices are set at the market level ,an arms length transaction can be carried within the firm.But there will be ineffective use of rape seed oil if transfer prices are considered to be constant.So optimal quntity of rape seed oil will not be used by the firm in downstream production.The firm would subsidize  its upstream division when market prices are low .  When market prices are high , the firm would support  its downstream production.