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2.4.1. Transaction Cost

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To compete in increasingly competitive economic environments, decisions to offshore company activities are essentially driven by factors related to costs of production, distribution and productivity (Olson, 2006). When deciding which IT activities shall be outsourced, Transaction Cost Theory is among the most frequently mentioned theoretical foundations.

Transaction cost theory, which was pioneered by Coase (1937), is based on the assumption that human beings are utility maximizers and firms are profit maximizers. The paradigmatic question of transaction costs theory is the ‘make-or-buy’ decision: should a firm carry out an economic activity in-house or should it be outsourced? According to this theory, outsourcing is only desirable as long as the costs of related asset specific investments, contractual incompleteness and search efforts are lower than the expected cost advantage. In making outsourcing decision, firms balance the savings made in production costs against the transaction costs that result from outsourcing. If the savings in production costs exceed the transaction costs then it is worth outsourcing and vice versa (Qu and Brocklehurst, 2003). In addition, by moving production outside of the core firm to other specialised companies, the core firm gains access to more experience, makes better use of available production facilities, and capitalises on economies of scale, all of which can lead to lowered production costs (Anon, 2004).

Transaction theory has often been used for research in the Information systems field in an attempt to explain the impact of IT on the boundaries of a company (Huang and Yang, 2000). According to Bryson and Ngwenyama (1999), it provides a set of principles for analyzing buyer-supplier transactions and identifying the most efficient way of structuring and managing them. This concept, when projected on the field of IT outsourcing could, for instance, reflect the transactions between the outsourcing company and the provider (Amberg et al., 2005). However, only qualitative statements can be made about the changes in transaction costs which vary with the organizational solutions of offshoring.

Yordon (2004) argues that as telecommunications technology continues to improve and as the cost of such technology continues to drop, the practice of offshore outsourcing becomes more significant. The reason for this, he explains, is that less and less of the knowledge work will actually be required to be done where the customer/consumer is physically located. Additionally, the lowering of costs in the software industry is making it possible for smaller firms to compete much more readily with larger firms.

Corbett (2003) indicates that vendor prices in developed countries may be limited by the high cost of living in those countries. The cost savings from offshoring are primarily the result of differences between the developed and developing countries in the unit cost of labour, the worker compensation (wages and benefits) that must be paid to produce one unit of goods or services. Unit labour costs are lower for certain services in developing countries primarily because of the significant difference in the gross salaries of engineers between these countries. Savings up to 60 % are possible (Trampel, 2004). However, unit labour costs also depend upon the productivity levels of workers. Besides, differences in unit labour costs can result from differences in costs of employee benefits, such as health care and pension benefits. Cost savings can also be affected by currency exchange rates, countries’ tax policies, and government-provided incentives such as tax rebates.

In addition, according to Dhillon (2002), outsourcing cost benefits usually occur from economies of scale. He argues that vendors can realise reduced costs in the areas of technology acquisition by obtaining software and hardware products with decreased incremental costs per unit of power. Once the system is up and running, the offshore firms may need fewer more equipment and trained staff. However, some authors think that even savings obtained by large organisation from economies of scale are largely non significant. Yordon (2004) advocates that workers in developing countries could not compete with developed countries when cost of entry included the expensive mainfraim computers. Farrell (1999) considers that outsourcing vendors are aware of the fact that over the long term (12 months or more) the cost of hardware will always drop, sometimes dramatically. This implies that organisations could be locked into long contracts at higher historical prices.

Offshoring has several costs associated with it, including costs to start up an offshore operation and to manage and train an offshore workforce. In a more detailed approach, Schwarz, reported by Amberg et al. (2005), projects the four types of transaction costs onto the field of IT outsourcing:

 Search costs: For identifying and evaluating potential partners.

 Contract costs: Associated with the negotiation and writing of an agreement with the outsourcing provider.

 Monitoring costs: Ensure that all parties fulfil their contractual obligations.

 Modification costs: Resulting from either changes in performance on the part of the provider or changes in regard to external conditions.

Coward (2003) research showed that firms indicated that cost was a key factor so far as quality was compromised. However, when firms outsource processes that require the transfer of a large amount of tacit knowledge, they have to invest time and effort in training providers’ employees. Second, some processes take a long time to stabilize when companies offshore them. In both cases, the cost of switching from existing providers is very high (Aron and Singh, 2005). The McKinsey Global Institute approximates the savings in wage costs at about 45-55% notwithstanding the additional costs caused by increased demand for communication and by the management of the offshore project (McKinsey, 2003). However, according to Yordon (2004), a cost

differential in the region of 5 to 10% is unlikely to be a sufficient persuasive factor to justify locating offshore, especially for one-time projects. In addition, some experts have noted that wages of workers in developing countries are rising more rapidly than U.S. wages, therefore shrinking the cost savings of offshoring over time (GAO, 2005).

Moreover, cost generates the most disagreements between vendor and client. Farrell (1999) suggests that savings can be achieved in areas where services require higher capital cost for equipment for service delivery. The problems, he argues, may be as a result of hidden costs that have not been considered and lack of proper measures. Clients fail to define what constitutes excess charges, i.e. issues generally arise from lack of understanding of what is covered or not by the fixed costs (Lucas, 2004). Customers may subsequently be charged excess fees for services they assumed were covered within the contract. One company was charged almost $500,000 in excess fees the first month into a contract (Lacity and Hirshheim, 1993).

In general, offshoring initiatives that have cost savings as their raison d’être don’t allow companies to capture greater revenues from the market. That’s because such companies don’t commit themselves to the organizational changes that are necessary for offshoring to help them, say, customize products or services, lock in buyers, compress new product-development cycles, or enhance profit margins. (Aron and Singh, 2005)

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