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TECHNICAL | TRANSACTIONS COSTS THEORY Give and take Richard Smith An understanding of transactions costs and network organisations is vital for the final level Business Strategy paper learning outcome in the “evaluating strategic options” section of the Business Strategy syllabus is “evaluate and recommend appropriate changes in organisational structure”. The syllabus content refers to “the basics of transaction cost analysis and the implications for the location of assets, knowledge, people and activities inside or outside the organisation”. So, what is the connection – what is transactions cost theory? The root of the theory is vested in market economics. In simple terms, markets operate where there are buyers and sellers. A market price is produced for a good or a service, but a contract must be established to ensure effective and efficient performance associated with the agreement or deal struck. These agreements can be regarded as transactions. There are costs associated with making a transaction and acting under its terms. Apart from the costs of ordering, there may be costs associated with negotiations resulting from changes or unforeseen events, or incremental variations to the contract. The Economics of Strategy (D Besanko, D Dranove and M Shanley, New York, John Wiley, 2000) defines an arm’s-length market transaction as “one in which autonomous parties exchange goods or services with no formal agreement that the relationship will continue into the future.” Such arm’s-length transactions are regulated by contract law and this results in costs being incurred by the litigants. In any transaction, a contract protects the parties to the agreement. Contracts permit transactions to proceed in a sequential manner. A supplier provides goods or services and the purchaser then has a contractual obligation to pay, providing that the terms of the agreement have been met. The contract protects the supplier in case the buyer refuses to pay. A payment made on receipt of the goods or services, as in a shop, is a simultaneous contract rather than a sequential one. Estab- A lishing contracts for performance results in costs for both parties. Contract law reduces unforeseen problems, but it does not prevent them. If the contracting parties do not foresee all circumstances and contingencies, the contracts will be incomplete. Incomplete contracts lead to transactions costs. The Economics of Strategy states that a relationship-specific asset (R-SA) is “an investment made to support a given transaction”. It explains that such an asset cannot be employed on another transaction without some opportunity cost resulting from loss of productivity from the R-SA, or the need to incur further cost to change its use. Therefore an R-SA ties the parties together. The Economic Institutions of Capitalism (O Williamson, Free Press, New York, 1985) explains how a relationship changes from a “bidding situation” where buyers select from a number of suppliers to a “small numbers” bargaining situation after investment by one or both parties in R-SA as a “fundamental transformation”. The Economics of Strategy states that suppliers view this situation as a long-term arrangement and may reduce quotes to win a contract. Subsequently, they may use unforeseen events as a reason to increase the price. The buyer, reluctant to incur the costs of changing supplier, may agree. At the bidding stage, the buyer may share information with other suppliers in case the contract breaks down. This causes the supplier and the buyer to be suspicious of each other after the contract is established and may mean that they miss opportunities to improve efficiency. R-SAs may be in various forms: l Site specificity: location of assets close together to cut transport and stock costs. l Physical asset specificity: changing the construction or engineering of an asset to tailor it to the transaction. l Dedicated assets: acquiring an asset in order to complete the contract. l Human asset specificity: teaching employees skills to carry out the contract. These may be tangible, such as handling a new piece of equipment, or intangible, such as intellectual property. l Brand name capital specificity: when a brand is associated with a specific family of products or services, such as the international goods courier DHL. l Temporal specificity: providing services at a specific time – for example, airlines need to book landing slots at an airport. R-SAs may therefore relate to the buyer of goods and services as well as the supplier. Network organisations are defined in Management Accounting Business Strategy (A Sims and R Smith, CIMA Publications, 2001) as “those which rely on relationships with other organisations to carry out their work”. Such organisations may rely on others for core as well as ancillary services. Examples of such organisations include local government authorities and UK hospitals, airlines and railways. Many higher education establishments employ teachers on part-time contracts. Network organisations can involve contract staffing, using particular capital assets, outsourcing and relying on external organisations for referred business. This is nothing new. Networking relies on market forces to meet customer demands. If another supplier is cheaper than the in-house source at an adequate standard, it should be performing the activity. This will improve long-term shareholder value. Transactions cost analysis requires firms to assess supply costs and consider how they can improve shareholder value. Traditional organisational hierarchies must be broken down to establish network organisations. It would be interesting to know whether the development of transactions cost analysis has influenced this process. n Richard Smith is the examiner for the final level Business Strategy paper March 2002 CIMA Insider 21