Download Cost theory final

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
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