Eight to Late

Sensemaking and Analytics for Organizations

To outsource or not to outsource – a transaction cost view

with 11 comments

One of the questions that organisations grapple with is whether or not to outsource software development work to external providers. The work of Oliver Williamson – one of the 2009 Nobel Laureates for Economics – provides some insight into this issue.  This post is a brief look at how Williamson’s work on transaction cost economics can be applied to the question of outsourcing.

A firm has two choices for any economic activity: performing the activity in-house or going to market. In either case, the cost of the activity can be decomposed into production costs, which are direct and indirect costs of producing the good or service, and transaction costs, which are other (indirect) costs incurred in performing the economic activity.

In the case of in-house application development, production costs include developer time, software tools etc whereas transaction costs include costs relating to building an internal team (with the right skills, attitude and knowledge) and managing uncertainty. On the other hand, in outsourced application development, production costs include all costs that the vendor incurs in producing the application whereas transaction costs (typically incurred by the client)  include the following:

  1. Search costs: cost of searching for providers of the product / service.
  2. Selection costs: cost of selecting a specific vendor.
  3. Bargaining costs: costs incurred in agreeing on an acceptable price.
  4. Enforcement costs: costs of measuring compliance, costs of enforcing the contract etc.
  5. Costs of coordinating work : this includes costs of managing the vendor.

From the above list it is clear that it  can be hard to figure out transaction costs for outsourcing.

Now, according to Williamson, the decision as to whether or not an economic activity  should be outsourced depends critically on transaction costs. To quote from an article in the Economist which describes his work:

…All economic transactions are costly-even in competitive markets, there are costs associated with figuring out the right price. The most efficient institutional arrangement for carrying out a particular economic activity would be the one that minimized transaction costs.

The most efficient institutional arrangement is often the market (i.e. outsourcing,  in the context of this post), but firms (i.e. in-house IT arrangements) are sometimes better.

So, when are firms better?

Williamson’s work provides an answer to this question. He argues that the cost of completing an economic transaction in an open market:

  1. Increases with the complexity of the transaction (implementing an ERP system is more complex than implementing a new email system).
  2. Increases if it involves assets that are worth more within a relationship between two parties than outside of it: for example, custom IT services, tailored to the requirements of a specific company have more value to the two parties – provider and client – than to anyone else. This is called asset specificity in economic theory

These features make it difficult if not impossible to write and enforce contracts that take every eventuality into account. To quote from Williamson (2002):

…. all complex contracts are unavoidably incomplete, on which account the parties will be confronted with the need to adapt to unanticipated disturbances that arise by reason of gaps, errors, and omissions in the original contract….

Why are complex contracts necessarily incomplete?

Well, there are at least a couple of reasons:

  1. Bounds on human rationality:  basically, no one can foresee everything, so contracts inevitably omit important eventualities.
  2. Strategic behavior: This refers to opportunistic behavior to gain advantage over the other party. This might be manifested as a refusal to cooperate or a request to renegotiate the contract.

Contracts will therefore work only if interpreted in a farsighted manner, with disputes being settled directly between the vendor and client. As Williamson states in this paper:

…important to the transaction-cost economics enterprise is the assumption that contracts, albeit incomplete, are interpreted in a farsighted manner, according to which economic actors look ahead, perceive potential hazards and embed transactions in governance structures that have hazard-mitigating purpose and effect. Also, most of the governance action works through private ordering with courts being reserved for purposes of ultimate appeal.

At some point this becomes too hard to do. In such situations it makes sense to carry out the transaction within a single legal entity (i.e. within a firm) rather than on the open market. This shouldn’t be surprising: it is obvious that complex transactions will be simplified if they take place within a single governance structure.

The above has implications for both clients and providers in outsourcing arrangements. From the client perspective,  when contracts for IT services are hard to draw up and enforce, it may be better to have those services provided by in-house departments rather than external vendors.  On the other hand,  vendors need to focus on keeping contracts as  unambiguous and transparent as possible. Finally, both clients and vendors should expect ambiguities and omissions in contracts,  and be flexible whenever there are disagreements over the interpretation of contract terms.

The key takeaway is easy to summarise:  be sure to consider transaction costs when you are making a decision on whether or not to outsource development work.

Written by K

October 29, 2009 at 10:03 pm

11 Responses

Subscribe to comments with RSS.

  1. […] To outsource or not to outsource: a transaction cost view « Eight to Late eight2late.wordpress.com/2009/10/29/to-outsource-or-not-to-outsource-a-transaction-cost-view – view page – cached One of the questions that organisations grapple with is whether or not to outsource IT work to external providers. The work of Oliver Williamson – one of the 2009 Nobel Laureates for Economics –… (Read more)One of the questions that organisations grapple with is whether or not to outsource IT work to external providers. The work of Oliver Williamson – one of the 2009 Nobel Laureates for Economics – provides some insight into this issue. This post is a brief look at how Williamson’s work on transaction cost economics can be applied to the question of outsourcing. (Read less) — From the page […]

    Like

  2. Social comments and analytics for this post…

    This post was mentioned on Twitter by rharbridge: To outsource or not to outsource – http://is.gd/4H80q – A transaction cost view…

    Like

    uberVU - social comments

    October 30, 2009 at 5:32 am

  3. […] fall into this category – as examples see this post for an example drawn from psychology and this one for one drawn from economics.  Unfortunately these fields are not considered by the […]

    Like

  4. […] I’ve written in my post on outsourcing and transaction costs, parties involved in contractual agreements need to take a farsighted view. Such a view would […]

    Like

  5. […] a post entitled, To outsource or not to outsource, I discussed how transaction cost theory can provide organisations an insight into whether or not […]

    Like

  6. […] costs such as those incurred in communication, supervision of staff at remote locations etc. See my post on a transaction cost view of outsourcing for more on […]

    Like

  7. […] to manage and perhaps more importantly, not everything can be contractualised. See my post on the transaction cost economics of outsourcing for more on this […]

    Like

  8. […] years ago, I wrote a post applying ideas of transaction cost economics to the question of outsourcing IT development work. […]

    Like

  9. Excellent job. It really helped put capture centers in a different footing when comparing them against 3rd party IT service providers!

    Like

    Roman Lopez

    October 31, 2013 at 4:27 pm

  10. […] One of the main reasons for outsourcing IT is to reduce costs. Yes, I am aware that many decision-makers claim that their primary reason is to reduce complexity rather than cost, but the choices they make often belie their claims.  The irony is that in their eagerness to control costs, they often end up increasing them because they overlook hidden factors.  I explain this in brief below, drawing on my post on the transaction costs of outsourcing. […]

    Like

  11. […] outsourcing arrangements fail because customers do not factor in hidden costs. In 2009, I wrote a post on these hard-to-quantify transaction costs. The following short video (4 mins 45 secs) summarises […]

    Like


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: