Transaction Cost Approach to the Outsourcing Decision Problem

Transaction Cost Approach to the Outsourcing Decision Problem

Dilek Erdogan
Copyright: © 2020 |Pages: 16
DOI: 10.4018/978-1-7998-0333-1.ch012
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Outsourcing has become a management tool that is increasingly involved in the manager's agenda, but the decision to outsource is a problematic issue for decision makers in organizations. Outsourcing provides many benefits but also includes many risks, so every outsourcing agreement does not result in success. This chapter aims to provide a better understanding of the outsourcing problem in light of transaction cost economics. For this purpose, the concept of outsourcing is first explained. The transaction characteristics and the behavioral assumptions of the theory, which play a role in increasing or decreasing transaction costs, are clarified. Finally, governance decision (outsource or not) and some critical issues (safeguarding mechanism against opportunistic behavior by supplier, adaptation, and performance evaluation problem) that will arise after the outsourcing decisions are discussed.
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The outsourcing discussion refers to a situation which is traditionally well known in theory and practice as “make or buy” a decision. One of the traditional definitions of outsourcing is “outside resource using” (Quinn & Hilmer, 1994). Outsourcing is the handover of an activity to a supplier; it is an alternative to internal production (Aubert, Patry, & Rivard, 2002). Outsourcing subject, outsourcing object, outsourcing partner, and outsourcing design are four major elements of outsourcing. Outsourcing subject is the economic institution which decides outsourcing decision (or not). Outsourcing objects are transaction or transactions that are outsourced. Transactions can take place at different levels of activity of an organization and activities of an organization are divided mainly into four groups: the core business activities (activities related to the existence of a company), core-close activities (linked directly to core activities), core-distinct activities (supporting activities), and disposable activities (activities with general availability). For example, while information technology is a supportive activity, the flight operation is the core activity for an airline company. The decision to outsource support activity or core activity will be at different levels of difficulty because outsourcing of the core activity will be a more strategic decision, while the outsourcing of support activity will be a more operational decision. All potential suppliers who can provide the activities needed by the organization are called outsourcing partners (Arnold, 2000). The outsourcing design is a matter of governance structure and will be explained in more detail in the following sections.

Outsourcing has become a vital source of competitive advantage because it provides several benefits for organizations, such as reducing the cost of ownership of products/services, resolving technical problems without increasing the number of staff, and enabling the company to focus on its core business. However, it is not always easy for to organizations to manage outsourcing deals as it also involves many risks, such as increase of dependency on the supplier, loss of knowledge of how to conduct business, the difficulty of calculating transaction costs, and opportunist behaviors by the supplier. These risks of outsourcing lead to failures in some situations, so it is vital that managers have a good understanding of what makes outsourcing useful. For instance, according to a survey conducted by Deloitte Consulting in 2012, it was found that 48% of companies were not satisfied with the IT outsourcing contract (Qi & Chau, 2015). Given all these risks, it is essential that decision-makers know what increases or decreases transaction costs to achieve the set goals.

The transaction cost economy (TCE) focuses on whether the transactions are more effective through which mechanism (hierarchy or market). This also refers to as make (refers to hierarchy) or buy (refers to market) decision in the transaction cost economics (Williamson, 1998 p. 30). This chapter's objective is to provide a better understanding of economic factors affecting outsourcing decision, and governance of outsourcing transactions in the light of transaction cost economics.

Key Terms in this Chapter

Adaptation: The level of difficulty in adjusting the outsourcing contracts to the situation in the face of changing situations.

Task Complexity: The degree of difficulty in determining the standards and performance evaluation of a task.

Moral Hazard: It is an asymmetric information problem that occurs as a result of the secret actions that take place after the contract is signed.

Transaction Cost: Transaction costs are all expenses incurred when purchasing a good or service.

Outsourcing: The transfer of an activity of organization to an external supplier.

Contract: A formal agreement between the buyer and the seller.

Exchange Relationship: A commercial relationship between the buyer and the seller, which may be short or long term.

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