An outsourcing decision? Turn to economic theory

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Isak Marais.jpgTransaction cost economics provides further insight into the total cost of a commodity and offers a guiding hand to any organisation struggling with a decision to outsource, Isak Marais, MD of Total Safety Solution provider Bramhope, tells SmartProcurement.

Transaction cost reasoning often involves considering as "transactions" not only the obvious cases of buying and selling, but also day-to-day emotional interactions, informal gift exchanges, etc. Williamson, the father of Transaction Cost Economics, was awarded the 2009 Nobel Prize in Economics for his research.

To understand the transaction cost of an organisation one must examine the “Hierarchy of Transaction Cost”, explains Marais. Two sub-sections are relevant: first, the size of the organisation and second, the transaction properties.

Size of the organisation.jpgThe size of the organisation

The model alongside shows the Hierarchy Cost within the supplier and customer and highlights the market transaction cost. This can be the first benchmark tool.

An organisations’ level of hierarchy influences transaction costs as increasing levels of hierarchy add to transaction cost. Subsequently, the theory suggests that large hierarchies are inefficient at purchasing from a category of spend that is a small percentage of overall spend and should outsource purchases from these categories. E.g. Personal Protective Equipment (PPE), which represents less than 1% of the total procurement spend of large organisations.

Transaction properties.jpgTransaction properties

When examining transaction properties there are two factors to be considered: one is environmental and the other human, as shown in the figure alongside.

Environmental Factors

Transaction cost economic theory says that the more frequently a transaction takes place the lower the transaction cost.

“Applied to the procurement of safety shoes at a mine one notes that this commodity is only procured once or twice a year. One can then assume that the transaction cost of this purchase will be higher than the procurement of fuel used at the same mine,” explains Marais

Furthermore, if there is uncertainty regarding demand for a commodity the transaction cost will be higher. Most organisations can only spend time and resources to plan on the procurement of items that will give them the greatest savings, and not on the small percentage items.

Similarly, if asset specificity is high then the transaction cost will be high. Asset specificity can be described as the asset’s uniqueness to the business, say Marais, for example, the asset specificity of a laptop purchased by a computer hardware company will be low, while the specificity of a laptop purchased by a dress-making company will be high.

Human Factors

Human factors are fundamental assumptions about behaviour of buyers and sellers in the transaction process.

The result of applying transaction cost economic theory to an organisation’s purchases is that it may pin point some commodities that can be outsourced, says Marais.

He offers Personal Protective Equipment (PPE) as an example commodity that is a small-percentage spend which benefits from outsourcing. “Even in mining and industrial sectors, few organisations can leverage PPE volumes, so it is a commodity that is mostly procured inefficiently in-house.

When outsourced to a PPE supplier, an organisation’s small PPE volume is incorporated into a much larger requirement enabling greater volume leveraging, lowering transaction costs.

However, he warns that outsourcing to an organisation that does not use an Information Technology system (for managing, monitoring and controlling spend) will not give you the potential savings.

For more information on taking steps toward outsourcing or implementing a PPE policy, contact Marais on isak@bramhope.co.za

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