To outsource or not to outsource – a transaction cost view

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.