Beyond Theory: Outsourcing Vs. Transaction Cost Economics

Businesses are driven by sales. If we ask a random group people who run or are involved with businesses about their primary objective, there’s a good chance that majority of them will be talking about selling more and more. Quite naturally, the words “sales maximization” have nearly become synonymous with the word “Business” yet not always sales maximization leads to profit maximization. When we speak about maximizing profits, we generally think about product pricing, increasing operation to reap scale economies, first mover advantage etc. and hence most of the frameworks and cases that we read in the books revolve around all these concepts. Yet maximizing profits is not always about optimizing prices, increasing demand or maximizing reach.

If you look at firms which have been successful in the long run, one concept gets repeated again and again- reduction of cost. And I believe most of you will agree with the fact that the game is actually not played on the revenues but on the contribution margins and hence reducing cost becomes vital for success. However, this is easier said than done. Any business, however small that might be, incurs many different types of cost and many a times these are in reciprocal to each other i.e. one increases if other is reduced. A common example could be the cost of automation and labour. If you invest in automating your assembly line, you may reduce your labour charges or if you don’t want to invest in automation, you need to invest in labour to keep pace with the increase in demand. Hence, it is important for firms to find that sweet spot that maximizes net contribution rather than net sales.

Firms are like human beings- they don’t like uncertainties. Our basic nature dictates that it’s better to keep everything under our own control rather than depend on someone else in matters that involve any uncertainty. Firms are like the same. But if firms decide to do everything on their own, will that be beneficial for them? Hence, at some point, a firm needs to draw a line as to what it can make and what they shall. And drawing this boundary gives birth to a phenomenon that is commonly known as “market transaction”.

Let us talk about some theory first. In 1975, an economist named Oliver E Williamson, now a Nobel Prize winner in economics, introduced a concept called Transaction Cost Economics (TCE) that defined why there must exist two separate entities- a firm and a market. Think of a firm. It is nothing but a machine that gives you certain pre-defined, standard outputs on the basis of some repeated, idiosyncratic transactions that occur in the background. Now think of a market that is efficient and ideal (basic assumptions are perfect information, rational actors, homogeneous goods, no liquidity constraints). Understand that if the market remains ideal, there is no advantage for a firm to not do these transactions in the open market and only because there are imperfections in the market a firm decides that there’s some value to be gained if it does them within its control.

To understand TCE, we need to look at its foundation. The first two elements are bounded rationality and opportunism; both have their roots sunk in behavioural economics. Because our decision-making capacities are dependent on information, one can become profitable by withholding them and convince another to become dependent. Think of an automaker that needs an engine as one of the key components for its cars. Yet if it lacks the capacity or information to build one itself, the engine supplier holds all the cards in this particular transaction.

Next elements in TCE are asset specificity, uncertainty and frequency. Imagine the same automaker who doesn’t know how to make engines. It is designing the entire car to make sure that the engine, supplied from outside, fits the body eventually. Now if suddenly the engine maker changes the design of the engines by even a slight bit, the automakers’ assembly line becomes completely useless. This is called asset specificity. Uncertainty, on the other hand, is a whole different ballgame. If the government suddenly reduces taxes on engines, the automaker doesn’t reap any benefit as it has already signed a legal contract to buy the engines for a fixed amount of money. Same goes for frequency. Once this transaction of buying engines gets repeated again and again, the firm starts to depend more and more on its supplier and the status quo gets tilted. Hence, there exist realizable benefits to do these transactions within the firm. If the automaker knows how to make engine itself, all these problems are optimized. Transactions that require relation-specific investment can cripple a firm if it loses control over it. And hence the basic instinct of doing everything defines a firm’s attitude. However, there seems to be one small glitch in this rosy theoretical approach- outsourcing.

Strategy is a very confusing field. At one hand we, theoretically, speak of doing things within the firm, but on the other we see numerous firms reaping huge value out of outsourcing their operations. In 2016, Deloitte conducted a survey among firms, 85% of which had annual revenue of USD 1 billion or more, belonging to different sectors to understand how outsourcing is becoming “The Strategy” to go with. The results are given in the figures-

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                                                                 (Source: Deloitte 2016 Global Outsourcing survey)

If you understand what we have spoken so far, these numbers go beyond our theoretical basis. Think of the IT segment. If 72% of a firm’s IT work is outsourced, a huge amount of information which may be critical to the business, lie beyond the control of the firm. Think about human resources. TCE talks about asset specificity and sunk cost which shall also include the cost of training of human assets and hence is preferred to be controlled within the firm’s boundary. But when we see firms generating value by outsourcing 47% of HR function- our theories hit a wall.

In reality, like our markets, our theories are not completely efficient. A firm generally has a core business and many a times focusing on that becomes more important than creating cross-functional expertise. If our automaker doesn’t even know how to make the other car parts in the first place, fitting the engine becomes an issue that it won’t even face. Hence minding your core business is extremely important. Next is globalization. Uncertainty principle of TCE considers socio-political volatility as a reason for firms to do transaction within its borders. Yet with more and more firms looking to do business in different countries, tapping into the local knowledge and expertise have become some of the most important success mantras even though it comes along with many uncertainties. Sometimes firms free up internal human resources to mitigate risks such as employee turnover, knowledge leaking out and in these cases, asset specificity makes very little mark. Take a look at the following figure to understand the economic benefit that comes with outsourcing-

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                                                                                        (Source: KPMG)

Doing business is like being in a relationship. Controlling everything to optimize result, though theoretically sounds amazing, in reality, isn’t something that happens. And firms need to understand this as fast as they can. Markets will always be inefficient but that must not mean that a firm needs to internalize everything. When a firm sees sources of cheap labour in a country to which it can outsource some part of its operation, the only question remains is to whether or not they can live with the uncertainties. In today’s world, all markets are interlinked. A recession in the US will always pull the Sensex down and hence firms need to understand that like the markets, inefficiencies are interlinked as well. Wherever you may go, you will have to deal with them and hence it becomes just a matter of cost-benefit analysis.

My article started with the theme of cost reduction and I will finish with that as well. Reducing cost doesn’t mean not incurring them completely- which may be considered the ideal scenario but can’t be the real deal. Costs are inevitable and hence maximizing contribution margin should be done by not looking at ideal or theoretical concepts. Firms need to understand that transactions are not isolated events. One transaction lead to another and hence contribution from a transaction is not only the direct benefit it creates but also the associated benefits it generates in other transactions. At the end, everything boils down to money and firms must look at the reality to earn them.

 

Author

Anirban Sinha,

Batch of 2016-18

IIM Rohtak

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