Economic factors of transaction costs


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Oliver Williamson examined economic factors in terms of transaction costs.   These costs are those expenses associated with performing a specific activity.  The fundamental Williamson proposition was that free market allocation would result in a balance of internal sourcing and outsourcing that would minimize the transaction cost.  Outsourcing creates a situation where external firms can behave opportunistically at the expense of their customer.  Service provider withholding poor performance information to ensure its operational success.  Such information withholding could result in a major problem for the service provider’s customers.

 

If only a few companies exist with capability to perform the required logistics service,

One that approximates monopoly power replaces the ideal free or competitive market.  This situation is further complicated if the requested logistics service require transaction specific assets such as dedicated trucks, buildings or wok forces.  In the event of cancellation, such customized assets may not be easily transferred to other customers.

 

Transaction cost analysis suggests that logistics activities be performed internally if the transaction costs are lower than expenses associated with outsourcing.  Internal costs are usually lower when (1) only a few potential third-party suppliers are available for outsourcing, (2) transaction- specific assets are required, or (3) various suppliers of such services are in a position to take advantage of the transaction setting.

 

The trade-offs depend on which party is best positioned to achieve i.e. best economies of scale.  For example, when considering outsourcing or owning a warehouse, volume is a critical factor.  Suppose the product requiring storage follows an erratic demand pattern.  On average, 25000 units need to be stored to meet monthly requirements.  However, peak storage demand requires 50,000 units, while the lowest point of seasonality requires only 5,000. If a privately owned warehouse is used, it must have the capacity to hold 50,000 units.  When demand justifies only 5,000 units storage, the warehouse would be operating at approximately 10 percent of capacity (5000/50000 = 10percent capacity). Under such utilization, fixed, overhead, labour and managerial expenses would be spread over so few units that the cost per unit would be very high.

 

On the other hand, outsourcing to a public warehouse could result in standard per unit cost that is independent of month-to-month storage requirements.

 

When outsourcing is outsourced, customer typically negotiates a rate that requires it to pay only for space used.  Therefore, the price is the same per unit whether the firm stores 5,000 or 50,000 units.  If the price per square foot is $1.50 and a unit takes up 2 square fees, the total charge per unit is $3.00, regardless of the total no of units stored. The level of rate typically charged would reflect average utilization as contrasted to either a minimum or maximum.

 

Alternative opportunity cost of capital is one such expense involved in outsourcing.  A private trucking fleet requires substantial equipment investment. To fully evaluate outsourcing, an enterprise should consider alternative uses of the capital that would be invested in a private fleet of trucks.  For example, the same amount of money could be used to increase manufacturing capacity, improve logistics facilities, or expand other aspects of the business.  The enterprise must determine which types of investment offer the best long-term advantage.

 

Another consideration is cost associated with obsolescence. Firm’s investment in technologies, which can become obsolete before the enterprise can fully amortize the cost.  In such case, technology may not have paid for itself in productivity and efficiency before it must be replaced.  Outsourcing logistics activities means that third party service provider is responsible for technology investments, and this reduces the risk of obsolescence.  Because of high volume usage, service providers will amortize cost of technology investment before they become obsolete. Furthermore the service provider is forced to update technology, to maintain attractiveness to their customer base.

 

Final important consideration in outsourcing is related to labour.  When moving from internal to external performance of logistic, the labour requirements and management responsibilities of the customer will be reduced or shifted to service supplier.  This shift affects cost like early retirement, layoffs, reassignment morale, productivity unionization and retaining.  And while moving to logistical service in-house from a third party provider, hiring, training, internal labour shifts and implementation time are the key considerations that may serve to limit flexibility.

 


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