Transaction costs occur whenever a good or service is transferred from a provider to a user.
If the finance director (FD) of a listed company is tasked with lowering the transaction cost of the finance department in order to increase investment returns and deliver the most economically viable transaction solution to the shareholders, what will the FD need to consider?
The FD will need to decide the appropriate governance structure, whether to internalise transactions and keep all of the roles undertaken in the department in-house, or whether to outsource and buy in some of the roles from the external market. When transactions occur within an organisation the transaction costs can include managing and monitoring the employees within the department and procuring inputs and capital equipment. The transaction cost of buying the finance services provision from an external provider can include the cost of supplier searching, negotiation, performance management and dispute resolution. Thus, the organisation of transactions or 'governance structure' can affect transaction cost.
There are two assumptions underlying the choice between market and internalising. They are bounded rationality and opportunism.
Bounded rationality refers to the fact that the FD will have limited capacity to understand business situations which limits the factors considered in the decision. Equate this to running your own business and using the services of an accountant who you pay fees to on an ad hoc basis for sorting out your VAT and tax. It is likely you have been using the services of the same accountant for a substantial period of time. You continue with the relationship knowing you will get a satisfactory service. You do not know that it is the best or optimal solution as you do not try other accountancy options. Why do you not try anywhere else? That is because of performance uncertainty. You cannot guarantee the quality of any other accountant and would put yourself at risk if you made a decision to purchase the services of an accountant you are not familiar with or have not heard about.
Opportunism refers to the possibility that the FD or the service provider will act in their own self-interest. That is, some people may not be entirely honest and truthful about their intentions some of the time, or they may attempt to make use of unexpected circumstances that gives them the chance to make the most from another party in a transaction. This creates mistrust between parties. In a world of opportunism, individuals cannot be assumed to keep their promises to fulfil their obligations and to respect the interests of their trading partners unless safeguards are in place. Equate this to obtaining information that your accountant is experiencing personal financial difficulties and cannot afford to lose any customers so you negotiate a reduction in the amount of fees you pay. You are making the most of the unexpected circumstances that your accountant is in and with no contract in place your accountant has no safeguard.
Transaction cost theory can be further impacted by three variables:
- Frequency – how often a transaction is made
- Uncertainty – from bounded rationality, opportunism and the difficulty of predicting the future
- Asset specificity – whether the product/service can be put to alternative uses
Frequency refers to the occurrence of the economic transaction. The FD is not likely to have strong justification for having 'in-house' provisions of a good or service that is rarely used. In principle, if some of the services of the finance department are used infrequently, and the services are not unique to the company, then it is likely that the market will offer scale and scope benefits, making outsourcing the favoured option. If you needed the services of your accountant every day, then it may be beneficial for you to employ an accountant on a full-time basis. Unless the accounting services are used frequently, then it can offer little advantage over the market where the accountant’s core competence is in the service required and, due to the service cost being spread across many customers, the service can be offered at a price that compares to the permanent structure of employing an accountant full time solely for your benefit.
Uncertainty causes problems because of bounded rationality and the danger of opportunism and the difficulty to predict possible events that may occur during the course of a transaction. Transactions that require a commitment over time have more uncertainty built in. The FD might be uncertain about whether the outsourced partner might go out of business or try to renegotiate the contract at some future time during the life of the contract. The FD will need to safeguard the contract to protect the company – this is likely to raise the costs of contract and performance management. You are unlikely to sign a long-term contract with your accountant as you might move location in the future making it too difficult to continue to use the services. In the absence of a contract with your accountant, it is also easy for you to walk away if the service delivery falls. If the service delivery falls for the FD this would be evaluated against the terms of the outsourcing contract and consideration would need to be given to using other suppliers or continuing with the same supplier.
Asset specificity relates to the specialisation of the asset. As assets become more specialised, they become less transferable to another provider or to the market. Economies of scale then become more easily organised internally. A central premise of transaction cost theory is that transaction cost increases when those who transact make greater asset-specific investments. The services required by the FD are likely to be required by many other companies making a market solution contract less complex and financially feasible. The skills of your accountant are required by many people who own their own business, so the cost of delivery is spread over many transactions allowing for you to obtain the service at a lower cost than the full-time employment of an accountant.
Clearly, it appears to be in the interest of the FD to internalise transactions as much as possible. The main reason for this is that internalisation removes the risks and uncertainties about future prices and quality. It allows the FD to remove the risk of dealing with suppliers and mistrust between parties. The FD will organise transactions to suit his or her own best interest and this activity needs to be controlled.
For many types of transactions, markets are the preferred governance structure because the supplier can provide incentives, the supplier reaps the full benefits or bears the full costs of its own activities, and thus has a strong incentive to maximise value of net production costs. The external supplier can also provide other benefits, such as improved performance because of greater specialisation in their area of expertise.
The corporate governance problem of transaction cost theory is the effective and efficient accomplishment of transactions by companies. Efficient governance structures depend on the characteristics of the transaction. Company management need to pursue the most economically viable solution and not their own interest.
Written by a member of the P1 examining team