Abstract Number: 003-0171
The Influence of Transaction Cost Economics and the Resource-based View on
the Outsourcing Process
Sixteenth Annual Conference of POMS, Chicago, IL, April 29 – May 2, 2005.
Ronan McIvor
University of Ulster
N. Ireland
Phone: 00 44 28 71 375275
Fax: 00 44 28 71 375323
THE INFLUENCE OF TRANSACTION COST ECONOMICS AND THE RESOURCE-BASED VIEW ON THE OUTSOURCING PROCESS
ABSTRACT
The trend towards outsourcing both locally and offshore has been increasing dramatically in many economies. Transaction cost economics and the resource-based view of the firm have made a valuable contribution to the study of outsourcing. However, this paper argues that neither transaction cost economics nor the resource-based view of the firm alone can fully explain the complexities of outsourcing. A critique of these theories as a means of understanding the complexities of outsourcing evaluation is presented. It is argued that integrating certain elements of these theoretical perspectives can inform the study of outsourcing both in theory and practice. A practical framework for outsourcing evaluation is presented which is influenced by a number of elements of these theories and empirical research undertaken. A number of outsourcing case studies are related to the outsourcing framework in order to illustrate both its explanatory and prescriptive nature.
INTRODUCTION
The drive for greater efficiencies and cost reductions has forced many organisations to increasingly specialise in a limited number of key areas. This has led organisations to increasingly outsource activities and services traditionally carried out in-house. Outsourcing involves re-drawing the boundaries between an organisation and its supply base. Although, the term outsourcing has become in vogue in the last number of years, organisations have always made decisions on determining the boundary of the organisation. However, rapidly developing product and service markets – both locally and offshore – and developments in information and communications technologies (ICTs) have accelerated the growth of outsourcing to encompass almost every organisational activity (McIvor, 2005). The research presented in this paper has evolved from a research project concerned with analysing both the theoretical and practical influences on the outsourcing process in a range of organisations. A key objective of this research was to develop a framework that would assist in advancing the study of outsourcing both in theory and practice. Two influential theories in the study of outsourcing have been transaction cost economics (TCE) and the resource-based view (RBV) of the firm. Both these theories make a valuable contribution to understanding the outsourcing process. However, this paper argues that neither the TCE theory nor the RBV alone adequately explain the complexities or the potential sourcing arrangements associated with outsourcing. It is argued that there are a number of inter-dependencies with each of the theoretical perspectives that can assist in outsourcing evaluation. The paper is structured as follows. In the review of the literature, the characteristics and limitations of the TCE and RBV as a means of understanding outsourcing are outlined. A practical framework for outsourcing evaluation is then presented which is influenced by a number of the interdependencies associated with each of these theoretical perspectives and the empirical research undertaken. The explanatory and prescriptive nature of the framework is illustrated by relating it to a number of outsourcing case studies from organisations that participated in the empirical phase of the research. The theoretical implications of the framework are then explored and finally conclusions are presented.
THEORETICAL INFLUENCES ON OUTSOURCING EVALUATION
This section outlines the characteristics and limitations of both TCE and the RBV as theories for understanding the complexities associated with outsourcing evaluation.
Transaction Cost Economics
The most influential theory on outsourcing has been Williamson’s theory of transaction cost economics (1975). Transaction costs analysis combines economic theory with management theory to determine the best type of relationship a firm should develop in the market place. The concept of transaction cost analysis is that the properties of a transaction determine what constitute the efficient governance structure - market, hierarchy or alliance. The primary factors producing transactional difficulties include bounded rationalityi.e. the rationality of human behaviour is limited by the ability of the actor to process information; opportunism i.e. people are prone to behave opportunistically which leads to self-interest; small numbers bargainingi.e. many bargaining situations are infrequent or involve small quantities where the cost of obtaining full information is prohibitive; information impactedness i.e. asymmetrical distribution of information among the exchanging parties that means that one party might have more knowledge than another. These transaction difficulties and associated costs increase when transactions are characterised by asset specificity (transactions which require high investments which are specific to the requirements of a particular exchange relationship); uncertainty (ambiguity as to transaction definition and performance); infrequency (transactions which are seldom undertaken)(Williamson, 1985).
The central theme of transaction costs theory is that the properties of the transaction determine the governance structure. Asset specificity refers to the non-trivial investment in transaction-specific assets (Williamson, 1985). The level of customised equipment or materials involved in the transaction between the buyer and supplier relates to the degree of asset specificity. When asset specificity and uncertainty is low, and transactions are relatively frequent, transactions will be governed by markets. Governance through markets can be described as discrete contracts that are short-term, bargaining relationships between highly autonomous buyers and suppliers designed to facilitate an economically efficient transfer of property rights (Ring and van de Ven, 1992). For example, manufacturing firms employ this governance structure in the case of standardised components that can be procured from a number of suppliers. High asset specificity and uncertainty lead to transactional difficulties with the transaction held internally within the firm – hierarchical governance. Medium levels of asset specificity lead to bilateral relations in the form of co-operative alliances between the organisations – intermediate governance. The two extremes of the sourcing decision are either vertical integration or outsourcing. The key issue in the sourcing decision is determining the boundaries between these two extremes. Williamson (1985) argues that the decision will always be made in relation to the scope for cost reduction and the importance of asset specificity. Therefore, the company should outsource activities if to carry them out internally would require excessive investment to get the lowest unit cost.
The fundamental issue associated with TCE is determining when a firm should use market governance, hierarchical governance or intermediate governance. The choice of governance option is determined by the cost of governance, the threat of opportunism and the level of uncertainty. The assumption of the TCE approach is that companies will be motivated primarily by efficiency considerations and choose the least costly of the options. For example, the cost of using market governance is less than the cost of both intermediate and hierarchical governance. However, the potential for opportunism associated with each governance option must be considered. The potential for opportunism exists when one party in the relationship has made a transaction-specific investment, whilst the other party has not made a similar investment. In this case, the party that has made the transaction-specific investment is prone to opportunistic behaviour from the party that has not made the investment. The TCE approach argues that the organisation can use the appropriate governance mechanism to reduce the threat of opportunism. For example, when the exchange is characterised by high levels of transaction-specific investments, the threat of opportunism can be reduced through employing hierarchical governance. Also, the level of uncertainty will affect the choice of governance option. In the case of a high degree of uncertainty, hierarchical governance becomes more attractive due to the increasing co-ordination costs involved in developing an appropriate contract. Williamson argues that in the case of a high degree of uncertainty, an organisation can develop a complex contract, make the transaction more standardised or employ hierarchical governance.
However, in some contexts this analysis is inappropriate. For example, an organisation may require a capability in order to compete effectively in a particular market. According to the TCE approach, if the level of transaction-specific investment is high then the organisation should employ hierarchical governance. This will involve either developing the capability internally or acquiring an organisation that possesses the required capability. However, it may be extremely costly for an organisation to pursue either of these options. Therefore, the decision does not depend solely on the level of transaction specific investment but also on the costs of internal development or acquisition. In the case of significant transaction costs, the organisation may have no choice other than to pursue other forms of governance even if the threat of opportunism exists. Barney (1999) argues that the opportunism that arises from transaction-specific investment is the cost of accessing capabilities that are too costly to obtain in other ways i.e. hierarchical governance. This analysis is particularly pertinent to high technology industries in which organisations have to rapidly access capabilities that are difficult to replicate. In fact, there is a growing body of literature emphasising the growing importance of capabilities in outsourcing decisions (McNally and Griffin, 2004; Madhok, 1996). The TCE approach provides a sound theoretical basis for understanding market versus hierarchical governance mechanisms for determining the boundary of the firm. However, the emphasis on market and hierarchical governance is a significant weakness of the TCE approach. Limited attention is given to exploring other potential governance structures, repeated transactions, the dynamic evolution of governance and transactions, and the key roles of trust and equity in inter-organisational relationships (Ring and van de Ven, 1992). The TCE approach fails to recognise that in many industries organisations are involved in complex and collaborative relationships that involve high levels of asset specificity as well as uncertainty and opportunism. In many cases, complex contracts alone cannot guard against the risks associated with uncertainty and opportunism. Relational mechanisms such as trust are regarded as substitutes for complex, explicit contracts and hierarchical governance (Adler, 2001).
The Resource-based View
An alternative theory to understanding the boundary of the firm is the resource-based view. Resource-based theorists view the firm as a unique bundle of assets and resources that if employed in distinctive ways can create competitive advantage (Barney, 1991; Peteraf, 1993). The resource-based view emphasises resources internal to the firm as the principal driver of firm profitability and strategic advantage (Barney, 1991; Conner, 1991; Prahalad and Hamel, 1990). The distinctive ways in which firms manage these assets and resources can result in superior performance and act as a durable source of competitive advantage. Also, rents derived from services of durable resources that are relatively important to customers and are simultaneously superior, imperfectly imitable, imperfectly substitutable, will not be appropriated if they are non-tradable or traded in imperfect factor markets (Barney, 1991; Dierickx and Cool, 1989; Peteraf, 1993). According to Barney (1991), a resource with the potential to create competitive advantage must meet a number of criteria including value, rarity, imitability and organisation. Resources and capabilities are considered valuable if they allow an organisation to both exploit opportunities and counter threats. Therefore, these resources should enable the organisation to meet the factors critical to success in their business environment. The rarity criterion is related to the number of competitors that possess a valuable resource. Clearly, where a number of competitors possess a valuable resource then it is unlikely to be a source of competitive advantage. A valuable resource that is unique amongst both current and potential competitors is likely to be a source of competitive advantage. Valuable and rare resources can be a source of competitive advantage. The imitability criterion is concerned with considering the ease with which competitors can copy a valuable and rare resource possessed by an organisation. In effect, this analysis is concerned with determining the sustainability of the competitive advantage in the resource. Finally, Barney (1991) argues that a firm must be organised to exploit its resources and capabilities. The organisation criterion includes a number of elements including the reporting structure, management control systems and compensation policies. It is important to emphasise that even though a firm may possess a range of valuable, rare and costly to imitate resources ineffective organisation will prevent the full exploitation of these resources.
Some of the proponents of the resource-based view have argued that it is more appropriate to explaining the existence of the firm than the transaction cost economics approach. For example, in Conner’s critique (1991) of the transaction cost economics approach, she explained that transaction cost economics emphasised the existence of firms as a way of minimising the opportunistic potential that arise when asset-specific investments are made. Therefore, she argued that transaction cost economics viewed the firm as an avoider of a negative opportunism, while the resource-based theory viewed the firm as a bundle of valuable strategic resources that can be a source of competitive advantage. Therefore, the TCE approach focuses primarily on the role of efficient governance – through transaction analysis – in explaining firms as institutions for organising economic activity, whilst the RBV focuses on the search for competitive advantage – through resource analysis. The TCE approach is focusing primarily on governance skills whilst the RBV focuses primarily on production skills. Reve’s (1990) perspective also proposed a resource-based critique of transaction cost economics. Reve (1990) defined strategy as ‘the match between a firm’s unique resources and its relationship to an ever-changing environment to attain its best performance.’ Building on Williamson’s work Reve has attempted to define the contractual theory of the firm. In Reve’s approach firms have unique resources (core competences and skills) that they must use responsively and with adaptability to meet the challenges of an ever-changing environment. Reve postulates that assets of high specificity, which are necessary to attain the firm’s strategic goals, represent the strategic core of the firm. The strategic core is the raison d’etre of the firm, defining its economic rationale within an industry. Using transaction cost analysis Reve (1990) argues that core skills or competences can be of four types including site specificity (resource immobility), physical asset specificity (technology advantages), human asset specificity (know-how advantages) and dedicated assets (specialised investments). A firm must defend these skills if it is to sustain its competitive advantage. Complementary skills can be dealt with through strategic alliances or co-operative relationships if they are of medium asset specificity with skills of low asset specificity being left to the market. Reve (1990) argues that the strategic core must be redefined as market and competitive forces continuously change. In a changing business environment a strategic core, which secured competitive advantage in the previous year, may be of no advantage in the current year.
The core competence concept has also evolved from the resource-based view of the firm. Core competence is important to the study of outsourcing, as it has proposed the internal organisation of the firm as the potential for competitive advantage. Obtaining, creating and developing certain capabilities is central to the core competence approach and has important implications for what activities should be kept within the firm and which should be external to the firm. The core competence approach and its relationship with outsourcing have evolved from the resource-based view of the firm. The ideas of core competence and its relationship to outsourcing have been influenced by the work of Prahalad and Hamel (1990). They contend that core competencies are not physical assets. Physical assets, no matter how innovative they may seem in the present, can be very easily replicated or become obsolete. Instead, Prahalad and Hamel argue that the real sources of competitive advantage are to be found in management’s ability to consolidate corporate-wide technologies and production skills into competencies that empower individual businesses to adapt rapidly to changing business opportunities.
There are two key limitations of the RBV in its ability to serve as a framework for explaining outsourcing:
The Relational View
Many of the proponents of the RBV have argued that competitive advantage is created from resources and capabilities that are owned and controlled within a single organisation. Therefore, resources that are internal to the organisation drive competitive advantage. However, a growing body of literature now exists in the area of inter-organisational relationships (Dyer and Singh, 1998; Poppo and Zenger, 1998). Proponents of this literature – sometimes referred to as the relational view – propose that it is a means of understanding how firms can gain and sustain competitive advantage. For example, Dyer and Singh (1998) argue that it is possible for organisations to combine resources in unique ways across organisational boundaries to obtain an advantage over their competitors. The relational view has evolved from the limitations of TCE in relation to potential governance structures and as an extension to the RBV. For example, Ring and van de Ven (1992) have argued that the tendency to focus on markets and hierarchies in the choice of governance in the TCE approach has left a significant void in understanding the potential alternatives. The relational view begins with an understanding of the firm. However, the relational view argues that the firm can develop valuable resources by carefully managing relationships with external entities including suppliers, customers, government agencies and universities. Therefore, a firm can gain and sustain competitive advantage by accessing its key resources in a way that span the boundaries of the firm. Competitive advantage can be embedded in a set of relationships across the boundaries of firms, rather than residing inside an individual firm.