It is the time of the year to plan ahead and a question arises at your board or budget meeting – should we outsource this function? Or hire someone to perform this activity? Several factors come to mind but the key factor is often the costs involved in either decision – both monetary and hidden costs. In this context, Transaction Cost Economics (TCE) provides a pertinent thought process for key management employees in a supply chain entity to determine if the entity would be more efficient if it ‘buys’ a function from independent firms in the market (eg. outsource manufacturing to China etc) or ‘makes’ the activities (eg. undertake production, set up retail stores etc) through internalisation of the function. This article seeks to provide guidance on the key characteristics of TCE and how they rationalise business considerations in a supply chain entity.

Navigating the dilemma

The theory of TCE was discussed by Ronald Coase when he reviewed the existence of firms in 1937. Most economic exchanges are carried out within firms mainly due to there being a cost to using the market – the ‘transaction cost’ such as costs relating to entering separate contracts with the external parties for each exchange transaction. If a decision is made to outsource a function or transact in the market, then management has to consider the costs of coordinating the transaction with the external provider. Various external service providers, however, have since arisen due to relatively greater economic viability in engaging external providers and greater efficiency or reduction of costs.

Firms can organise exchange by arm’slength market transactions or they can organise exchange internally by vertical integration. Managers determining an entity’s vertical boundaries within the TCE framework would therefore compare the costs of internal coordination (such costs include the costs of hiring and management supervision) to the costs of going beyond the firm’s vertical boundaries and using independent market firms and incurring the fees or costs payable to the external provider.

If management prefers to eliminate the costs of internal coordination and enjoy the benefits of economies of scale and scope that cannot be attained within the firm but are available in external providers, then management would decide to ‘buy’ from the market. Therefore if the cost of internalisation is higher than the cost of outsourcing a function or activity or if such function is beyond the firm’s core capabilities, then it may be worthwhile to engage an external service provider to provide such function.

TCE would however require management engaging an external service provider to consider the issues of costs incurred in searching for relevant suppliers, negotiating the terms of contracts, monitoring performance of obligations in contracts and, if necessary, enforcing any breach of the terms in the contract.

Coordination issues with market within the TCE framework

Firms going to the market would however observe that coordinating processes with the service provider is critical for purposes of managing the project and ensuring timely completion of the relevant function (i.e. production, distribution, audit etc).

Coordination is further affected if there is asymmetric information between parties that allows one party (with more information) to take advantage of the situation by trying to obtain further payments from the other party and possibly creating distrust between parties. Additional costs are then incurred when the less informed party tries to address this problem of opportunism and lack of trust through lengthy negotiations or renegotiating existing contracts.

In addition, risks of being held-up by the external provider may form a determinative factor for management to internalise critical functions within their vertical boundaries and avoid engaging an external service provider.

Therefore, entities can avoid coordination issues by internalising certain key activity, or entering alternative arrangements such as strategic alliances, investment or joint venture agreements with suppliers or partners if these arrangements can lower overall costs or provide strategic advantages to parties. Some firms also use a hybrid of ‘make’ and ‘buy’ models to efficiently carry out their business activities and overcome the coordination problems in the vertical chain. An example is hiring professionals for regular compliance functions and engaging external counsels for transactional or project matters.

TCE’s application on legal services and compliance functions

The use of TCE in the ‘make’ v ‘buy’ decisions by entities can be observed in legal and/ or compliance functions – whether one should instruct independent firms or hire in-house legal and compliance counsel to obtain the required services. For a ‘transaction’ with an external service provider, the risk of opportunism in the context of services increases when management, due to bounded rationality, is not adept at judging the amount of costs that should be incurred for the service being provided or how costs can be reduced. Such instances have therefore incentivised certain companies to internalise the legal and compliance functions by hiring experienced personnel (who can be close to the firm’s culture and business) to manage the legal and compliance risks internally.

However, by engaging an external service provider (or ‘buying’ from the market), the entities look to utilise the external firm’s expertise and leverage on its manpower resources and learning economies in the external service provider who could be aware of best market practices, in preparing detailed contracts or avoid breaches of regulations. Costs are therefore incurred (in the form of service fees) in the drafting and/ or enforcement of the terms and conditions of such contracts or due diligence exercises or compliance risk assessments and audits. The costs incurred in the engagement of the external firm may possibly be lower than hiring a full-time personnel if the services provided are not frequently required by an entity.

In that regard, it is widely observed that market entities are increasingly but implicitly using TCE framework in the hiring of personnel (similar to a ‘make’) to manage frequently incurred functions (operational matters or compliance with regulations) within the firm’s vertical boundaries, and engaging (‘buy’) services of external service providers for matters relating to disputes, transactions or where specialist knowledge is required.

Conclusion

Similarly, management in firms often face this dilemma in several other corporate decisions – whether the firm should ‘make’ or ‘buy’ the proposed activities and functions required for its business to maximise profits (or minimise losses) annually. It is a complex balancing act for management to reach a ‘make-orbuy’ decision as it involves a balancing of (tangible and intangible) benefits and costs of integration versus outsourcing. In a tough economic climate, management may need to conduct regular reviews of the need for internalising or outsourcing any function and process in a manner that helps to control costs or increase revenue (or both).

(The above is for general guidance only. Any views and suggestions expressed above are solely of those of the author. The author can be contacted at sunil.rai@rodyk.com.)