The Importance Of Transaction Cost Theory

Corporations are under tremendous pressure to cut costs. Outsourcing is a strategy that corporations are increasingly using to reduce costs and increase profitability. Although companies find outsourcing as a significant way to minimize costs they fail to realize the risks or costs involved. Transaction Cost Theory (TCT) helps managers recognized the true potential costs involved in outsourcing. In this paper I will explore the TCT and its various assumptions and factors. I will also look at the various criticisms of TCT.

Outsourcing services is quickly rising. The Financial Accounting Outsource (FAO) market reached $3.1 billion in annual spending last year, representing about $24 billion in total FAO spending. A new survey by the Everest Group indicates that this rate will continue or grow in 2010 (AccountingWEB). Outsourcing creates new opportunities as well as unrecognized hazards. The long term costs of these unrecognized hazards can greatly overcome any potential cost savings (Elram). Due to these potential costs, managers need to understand the true cost structure of outsourcing. Managerial decisions to outsource can be driven by three broad types of motivations: (1) It is possible to realize substantial cost savings by outsourcing a project, (2) it is possible to reconcile the divergent interests of the client and vendor to produce an outcome that is valuable to the client, and (3) the vendor’s expertise can successfully help accomplish the client’s project objectives. These broad motivations roughly correspond to the three theoretical perspectives of TCT; TCT represents one of the few coherent bases that managers can use when they make sourcing decisions (Aubert). The theory concerns itself with efficiency especially in the realm of transaction costs. TCT requires the decision maker to weigh all costs involved. Decision makers must then compare the costs of production and transaction within their organization versus the production and transaction costs associated with outsourcing. The theory only considered two alternatives, the firm makes the component itself or it buys it from an autonomous supplier. Thus mixed modes such as franchising, joint ventures are disregarded. (Williamson).

The transaction cost approach to the study of organizations has been applied at three levels of analysis. The first is the overall structure of the enterprise. The second focuses on the operating parts and asks which activities should be performed within the firm, which outside it and why. The third level is concerned with the manner in which human assets are organized (Williamson). Along these levels, one of the main research question that TCT seeks to address is why are some economic transactions internalized within the boundaries of the firm while others are procured to external parties? TCT argues that there are costs to conduct transactions through the market other than the apparent contract cost. Transaction costs are defined as the direct and indirect expenses of negotiating, monitoring, and enforcing explicit and implicit contracts between firms. TCT claims that these transaction costs driving economic organization are as important as production costs. (Martins) The central tenet of TCE theory is that exchanges or activities that incur high transaction costs are likely to be kept within firm boundaries, whereas transactions for which such costs are lower are more likely to be outsourced

The TCT starts with the basic assumption that economic transactions are hampered by incomplete contracts. Transaction cost theory assumes an incomplete contract setting. The transaction cost approach to the study of economic organization regards the transaction as the basic unit of analysis and holds that an understanding of transaction costs economizing is central to the study of organizations (Williamson).A transaction occurs when a good or service is transferred across a technologically separable interface. One stage of activity terminates and another begins. (Williamson). Williamson argues that two human and three environment factors lead to transaction costs (Aubert). The two human factors are 1) bounded rationality and 2) opportunism. The three environmental factors are 1) uncertainty 2) small numbers trading and 3) asset specificity.

The first human factor described by Williamson is bounded rationality which focuses on the individual’s inability to process large degrees of information and their difficulty in assigning probability values to the occurrence of future events (Martins)

Behavioral assumptions like bounded rationality is a potential reason that make some firms take advantage of measurement difficulties to overprice and/or underperform. This kind of behavior makes some agents develop a ‘cheating’ behavior. In order to avoid this ‘cheating’ behavior companies internalize and integrate the transactions. This leads us into the second human factor.

The second human factor described by Williamson regarding human behavior revolves around the fact that individuals may engage in behavior that is both subtly and overtly deceitful ex ante and ex post to agreeing to contracts. This is opportunism. Such opportunistic behavior might manifest itself in the form of the vendor taking advantage of the client after the outsourcing decision has been made-that is, during or after development. Threat of opportunism is defined as lack of trust that a vendor will honestly fulfill project obligations. The greater this threat, the greater the extent to which a client must implement complex and costly governance mechanisms to safeguard its interests in its transactions with a vendor. Since outsourcing involves significant hazards of opportunism, managers are likely to outsource a project only if they perceive ex ante that they are sufficiently protected from such opportunistic behavior. Trust between the client and vendor firms therefore reduces inter-firm transaction costs by lowering the perceived threat of opportunism.

Uncertainty is an environmental factor that influences transactions costs. Uncertainty is a straightforward assumption and it contrasts with the perfect information assumption of the neoclassical view. Information about the past, current and future states are not perfectly known. TCT predicts that a level of uncertainty is likely to affect whether a decision maker chooses to outsource (Aubert). The more volatile the supply market environment the less likely the offshore outsource. Transaction cost economics posits that in highly uncertain markets; firm prefers to perform a task internally.

The second environmental factor that influences transactions cost involves frequency of trading. Firms will be more likely to offshore larger volume professional service categories such as Accounts Payable and Tax. .Early on TCE suggests that outsourcing becomes cost prohibitive as the number of transactions increase. With the increase in IT knowledge these tasks are now dominated by fixed costs associated with monitoring and management systems rather than the variable costs once associated with the tasks. This has caused the cost curve to shift so that fixed set up costs outweigh the variable transaction costs in offshore outsourced professional services (Elram). In order for them to enjoy the economies of scale associated with their investment in setting up linkages and creating the systems for monitoring their offshore outsourcing suppliers, high transaction volume is necessary. (Elram) Frequencies of transactions or the volume are important to be considered because even given the previous assumptions if they are infrequent alternative governance structures may not be needed. The degree of frequency ranges from occasional to recurrent. (Martins)

The third and perhaps most important environmental factor is asset specificity. Asset specificity is both the most important dimension for describing transactions and the most neglected attribute in prior studies of organizations. The issue is less whether there are large fixed investments, though this is important, than whether such investments are specialized to a particular transaction. (Williamson) Williamson identified four dimensions of asset specificity: Site specificity, e.g. a natural resource available at a certain location and movable only at great cost; Physical asset specificity, e.g. a specialized machine tool or complex computer system designed for a single purpose; Human asset specificity, i.e., highly specialized human skills, arising in a learning by doing fashion; and Dedicated assets, i.e. a discrete investment in a plant that cannot readily be put to work for other purposes. The degree ranges from non specific to idiosyncratic (Aubert). Transactions that are supported by durable, transaction specific assets experience ‘lock in’ effects on which account autonomous trading will usually be supplanted by unified ownership. The essence of asset specificity therefore is that lock in effects occur which potentially lead to hold up problems. One party invests in an asset to support a transaction with another party. Or it might not be possible to use it to support any other transaction. It is specific to a particular exchange because it sustains its value only in the context of that exchange. An asset that is specialized is not necessary specific (Aubert). Overall the higher level of asset specific investment required the less likely the professional service category is to be offshore outsourced.

Transactional cost theory is not without its critics. Early critics argued that transaction cost overlooked the intracries of organizational power relations, trusts and other forms of social embeddedness (Foss). Critics also pointed out some of the problems regarding the basic assumptions such as opportunism in particularly motivation. The primary problem with the treatment of motivation in the theory is not opportunism per se, but rather that modern economic approaches assume that all motivation is of the extrinsic type. All behavior is understood in terms of encouragement from and external force, such as the expectance of a monetary reward. (Foss) The assumption of opportunism has been criticized for ignoring the contextual grounding of human actions and therefore presenting and under socialized view of human motivation and over socialized view of institutional control. TCT is also criticized for failing to point out how opportunism is reduced through alternative governance structures and there is a difference between the propensity to behave opportunistically and the psychological state of opportunism. Critics also challenge the notion that uncertainty is a threat. They state that uncertainty should be taken advantage of utilizing the entrepreneurial view point. Also, in discussions of firm boundaries, it is perhaps widely accepted that transaction cost theory does not do a satisfactory job in explaining ownership structures as joint ventures. (Kim)

Transaction costs theory has wide application in the social sciences, including economics, finance, marketing, organization theory, political science, sociology and strategic management. (Need first name) Coase who could be called the father of Transactional Cost Theory made some remarks in 2002 to an audience in Missouri. “Transaction costs, in my view, become the factor upon which the productivity of the economic system depends. And in consequence, economists should enlist the support of lawyers, sociologists, anthropologists, and others in our work in order to understand why   transaction costs are what they actually are (Coase)”  Transaction cost theory or transaction cost economics has become an increasingly important anchor for the analysis of a wide range of strategic and organizational issues of considerable importance to firms.