Make or Buy decision: Outsourcing - A successful method to reduce costs in business processes of international companies?

Table of contents

List of abbreviations

Table of figures

1. Introduction
1.1 The problem
1.2 Goal
1.3 ructure of the analysis

2. New institutional economics
2.1 The transaction cost theory
2.1.1 Definition of transactions
2.1.2 Types of transaction costs
2.1.3 Measurement of transaction costs
2.2 The property rights theory
2.3 The principal agent theory
2.4 Critical comments

3. Outsourcing
3.1 Definition of outsourcing
3.2 Types of outsourcing
3.3 Outsourcing contracts
3.4 International aspects of outsourcing
3.5 Chances and risks of outsourcing
3.5.1 Chances
3.5.2 Risks
3.6 Critical comments

4. Outsourcing of a warehouse at the company Fichtel & chs AG
4.1 The organisation
4.2 Definition of outsourced warehouse
4.3 Cause and goal of the outsourcing process
4.4 Realisation of the process
4.5 Critics and results
4.6 milarities and differences in theory and practise

5. Conclusion

6. List of literature

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

Table of figures page

Figure 1: Theoretical framework

Figure 2: Phases of transactions and transaction costs

Figure 3: Types of outsourcing

Figure 4: Chances of outsourcing

Figure 5: Risks of outsourcing

Figure 6: Concept of an outsourced warehouse

1. Introduction

During the last years international companies dealt with the question of optimal division of labour in cooperation with suppliers; especially in the automotive and supply industry². This question and its solutions decide of the competitive position of many companies in several industrial sectors. Major points in regard to division of labour are the areas of manufacturing-, quality-, logistics- and development functions. ch procedures create qualitative relationships between the parties involved³.

Another question concentrates on the maintenance or the change of company internal services e. g. cleaning, car pool, human resources, canteen and accounting. Although the core services of the companies remain the same, in these areas total cost reductions as well as flexible processes can be achieved⁴.

The process of optimal division of labour to be achieved by giving away internal functions to an external service provider, in economic literature is called outsourcing⁵.

Generally, corporations use outsourcing to target on cost-, flexibility-, time- and quality aspects⁶.

1.1 The problem

Each company which outsources an internal service, expects an optimisation in cost-, flexibility-, time-, or quality targets⁷. But nevertheless in some cases those expectations are not fulfilled⁸.

Depending on the function which is to be externalised, the outsourcing process varies in regard to the complexity, cost- and control efforts, communication, working time and amount of work⁹.

Outsourcing is linked to costs which arise during the externalisation process. The costs for the process can be budgeted , but however due to unforeseen circumstances the budget can vary. If the actual costs are higher than the estimated budget, the expected cost target may not achieved¹⁰.

Furthermore the providing of an external service has to be controlled by the customer. In general the providing of an external service is regulated by contracts. Those contracts include rights and duties of each party involved. A not fulfilment of the contract by the service provider means to the customer higher efforts to enforce his rights and moreover in worst case the need to reverse the whole outsourcing process.

The externalisation of a service includes the risk of a loss of know-how for the customer. Due to the fact that know-how and information have to be transferred between two different companies, the risk of a loss of know-how increases. Furthermore the communication flow between two different companies is affected by organisational barriers.

This shows that the outsourcing process is very complex and has to be planned, well organised, calculated and best possible executed to gain expected success.

1.2 Goal

The main target of this paper is split in two parts. The first point is to show and explain the relevant theoretical framework of outsourcing in regard to the new institutional economics theories. To define the term outsourcing and give an overview about this externalisation process as it is seen in economic literature is the second part of the main target.

Therefore the paper presents the transaction costs-, the property rights- and the principal agent theory. Furthermore it shows different types- and the international aspects of outsourcing and discusses the chances and risks of the process.

The sub target of the paper is to give an interlink between theory and practice by presenting an current example of outsourcing in an international context, moreover to find out similarities and differences between theory and practice.

1.3 ructure of the analysis

Due to the goal of this paper, the analysis starts with the outline of the problem, that expected goals within the outsourcing process may not be fulfilled. Thereby the analysis is focused on cost aspects, the control problem and possible lacks of information which arise by externalisation of an internal function¹¹.

In the second step the defined problem has been regarded from a theoretical point of view. The background for this problem, in economics is the new institutional economics theory. Afterwards the three sub theories of the new institutional economics the transaction cost-, the property rights- and the principal agent theory¹², are described and explained in detail. The main focus in this part of the paper is the transaction cost theory. The end of the theoretical part forms a critical review on the presented theories.

The analysis continues with a reflection of outsourcing. At the beginning the term outsourcing is defined. In addition to this, the different outsourcing types are shown and distinguished. Moreover it is given an overview about outsourcing contracts. Furthermore the international aspects of outsourcing are shown. At the end of this chapter, chances and risks are described in detail to show advantages and disadvantages of this externalisation method. Finally the literatures’ approaches in regard to outsourcing are evaluated and appreciated to show bottlenecks.

To build a linkage between theory and practice, in the forth chapter the outsourcing process of a warehouse by the Fichtel & chs AG is described - and finally evaluated in comparison to theory. First of all, to present the Fichtel & chs AG, the organisation is outlined. Further there is given a definition of the concept of an outsourced warehouse. In the next step, the companys’ cause for the consideration of the make or buy decision is explained and the expected goals are mentioned. Afterwards the executed process is exposed in detail. Hereby the focus is set on the quote evaluation and decision, the advantages for each of the involved parties as well as the allocation of the functions within the outsourced process. Moreover, doubts on this externalisation process, expressed by involved staff, and the realised results are presented to generate a critical point of view.

At the end of the fourth chapter theory and practice are compared. Herewith similarities and differences between the used theory and the presented example from practice are worked out. In particular cost aspects are considered, the risk of information loss and the control problem arising within the outsourcing process are determined.

The paper finishes with a conclusion and a brief outlook of the development of outsourcing in future.

2. New institutional economics

The new institutional economics target is to explain the global operations, in which imperfect actors, people with limited rationality and moral are dependent on each other in their economic acting¹³.

The new institutional economics are three theories assigned. These are the property rights theory - the theory about the rights of disposal - , the economical theory about substation - the principal agent theory - and the transaction cost theory¹⁴. The theory about the rights of disposal and the theory about substation deal with the analysis of institutional arrangements and the design of incentive systems. The transaction cost theory analyses the link between the execution of a bartering action and the therefore essential and relevant contractual and organizational framework¹⁵. Thereby legal-, economical- and organisational perspectives are combined¹⁶.

The following figure shows the starting point and the theoretical framework of the new institutional economics and the three theories, which are derived from it.

urce: according to http://www.aib.wiso.tu-muenchen.de/ lehre/ws0506/Grundlagen2/Reader-05.pdf¹⁷ Figure 1: Theoretical framework

2.1 The transaction cost theory

The basis of the transaction cost theory was developed by COA in 1937 to explain the question, why enterprises in a work-sharing economy build up¹⁸.

In the middle of the 1970’s this approach was seized by WILLIAMN¹⁹. nce this time the “the analyses of the efficient coordination form for a given task”²⁰is in the focus of the consideration. This development is called governance-approach in difference to the measurement-approach, which is used at the new institutional economics or rather the new institutional microeconomics²¹.

The transaction cost theory becomes increasing extension at the research of business administration²², as the following examples shows:

- establish a company²³,
- make or buy decision or rather decision about vertical integration (in the production)²⁴,
- organisation (in-house as well as external e. g. co operations)²⁵,
- make or buy decisions at the division of research and development²⁶and
- distribution decisions²⁷.

2.1.1 Definition of transactions

The main focus of the transaction cost theory is on transactions and the costs incurred by fulfil the transaction²⁸. , the analysed unit in the theory is the several transaction²⁹.

ill nowadays the term transaction is explained as the transfer of goods³⁰, although COMMONdefined transactions as the transfer of rights in the 1930’s³¹: “Transactions are not the exchange of commodities, but the alienation and acquisition, between individuals, of the rights of property and liberty created by society, which must therefore be negotiated between the parties concerned before labour can produce, or consumers can consume, or commodities be physically exchanged”³².

Transactions are among the agreement of the transfer also the required communicative negotiation in the run-up to the conclusion of a contract³³.

In this paper transactions should be defined as: actions or rather activities which can (but need not) cause the trade of commodities and services between subjects with property rights³⁴.

Transactions can be differentiated in in-house and external transactions. They are lead by adjustment (in-house transactions) or by the machinery of the market (external transactions)³⁵.

It is obvious that the term transaction costs is added from the both parts transaction and costs³⁶. At this the transaction is the condition or rather the reason for the accruement of the costs named by it³⁷.

Transaction costs are defined as costs which are caused development, classification, transfer and the enforcement of property rights³⁸. This means costs of information and communication, time and effort for the development, enforcement and control of the transfer of goods, services and disposal. Transactions costs serve as efficiency criteria for the evaluation and the assortment of property rights apportionments³⁹.

One of the main approaches of the transaction costs theory are contracts. In particular it is act on the assumption that every kind of act of barter can be seen as a contract. , any of this contracts can be analysed under the aspect of the economisation of transaction costs⁴⁰.

Any act of barter needs a explicit or implicit contract, which means a system of command and control. This is the framework for the planning, modification and control of the concrete performance of the task⁴¹. The costs for the development and the operation of systems of command and control are named transaction costs in the economic literature. These costs have to be differentiated from the productions costs, which are the costs of the fabrication of goods and services⁴².

Transactions can be differentiated, as mentioned before, by the specification of various categories of their properties⁴³.

stems of command and control differ in their adaptability and with it the involved costs. Not every system of command and control is useful for any transaction. Therefore the reduction of transaction costs results from the differentiated classification of transaction and system of command and control⁴⁴.

2.1.2 Types of transaction costs

A transaction consists of various processes, which all cause costs. As mentioned before these costs arise of information and communication, time and effort for the development, enforcement and control of the transfer of goods, services and disposal⁴⁵. For any transaction a contract is needed, which means a system of command and control⁴⁶.

Different contracts cause different systems of command and control and accordingly different amounts of transaction costs. Because of the choice of various forms of organisation had no specific consequence in reference to costs, there was no organisation problem. All contract costs would be neutral⁴⁷.

Transaction costs have to be differentiated from production costs. Both together are the total costs of every economic activity⁴⁸. By underlying the term production⁴⁹, production costs are the costs caused by the construction of goods and providing services⁵⁰.

Transaction costs are linked to the development and control of the transfer of goods and property rights respectively⁵¹and are a significant cost factor.

This is circumstanced by the fact that the amount of transaction costs in industrial societies is estimated about 50 percent of the gross national product⁵². The best part of these costs are developed in the last century⁵³.

In the following text these costs are explained in detail and differentiated. WILLIAMN differentiates - according to the term transaction, which means the phase of contract negotiations as well as the fulfilment of contract⁵⁴- ex-ante and expost transaction costs⁵⁵.

Ex-ante transaction costs arise by the search of a contract party, the concept and developing-, the negotiation- and the control of the agreement. The concept and the negotiation are focused on the provision for contingencies in future and also on the consideration of potential contract parties. Furthermore ex-ante transaction costs include the respective necessary adaptation in contracts. If the agreement is extensive or rather detailed, the costs for the concept and the negotiation of contracts tend to be higher than for less extensive or rather detailed contracts⁵⁶.

Ex-ante transaction costs are characterised by PICOT as cost of adoption and negotiation⁵⁷.

Agreements about the control refer to mechanism if problems develop by the contract fulfilment. The most studies about barters guess, that problems with contracts concern active laws. Furthermore it is guessed that the laws will be applied proper and with low costs by courts⁵⁸.

If this is right, the phase of the fulfilment of the contract is not relevant for ex-ante transaction costs. However in fact the most conflicts, also these which can be submitted to the court, settle by annulment of contract or self-help⁵⁹.

The reason for this is that agreements by courts are limited. the adoption is at least partial unfounded. Moreover with such an adoption does not consider the juristic and economic relevance of extrajudicial arrangements. To avoid this and to analyse transactions more realistic, the costs arise for the agreement about the control of the contract fulfilment are considered as ex-ante transaction costs (costs of control)⁶⁰. Ex-post transaction costs arise after the contract conclusion by the contract fulfilment.

WILLIAMN gives the following examples for ex-post transaction costs:

- costs for undesirable development⁶¹,
- costs of bargaining⁶²,
- costs for the development and implementation of a system of command and

control and the effort to assert reliable covenants⁶³.

Ex-post transaction costs are characterised by PICOT as costs of control and adjustment⁶⁴.

The following table shows a comparison of the phases of transaction and transaction costs by WILLIAMN and PICOT.

Abbildung in dieser Leseprobe nicht enthalten

urce: according to Matje, A. (1996), p. 78

Figure 2: Phases of transactions and transaction costs

It is to considered, that the phases before and after the contract conclusion are linked together in both approaches. A trade off between phase/s before and after the contract conclusion is adopted, that means both have to be seen simultaneous⁶⁵.

2.1.3 Measurement of transaction costs

The definite quantification of transaction costs is extremely complicated. This difficulty is currently judged as not conquerable⁶⁶.

Nevertheless, different approaches for the measurement of transaction costs exist.

- Indirect measurement of factors dependent on transactions or rather the calculation of quasi debentures of the analyses of vertical integration⁶⁷,

- approaches to calculate transaction costs on financial markets⁶⁸,

- calculation of transaction costs by the transaction sector of a national economy⁶⁹,

- integration of transaction costs in the operational accounting⁷⁰.

In the transaction costs theory the problem of the difficulty quantification is mitigated with the argument, that transaction costs arise always by the comparison of institutions⁷¹. This means one possible kind of contract conclusion is compared with another. , not the amount of transaction costs of several contracts but the difference of transaction costs between different contracts matters. In this case the not (monetary) quantifiable differences are important, because functional forms of organisation are rather different in their reasons than in their levels⁷².

In empirical studies the direct measurement of transaction costs is attempted extremely uncommonly.

¹ Note by the authors: Company name.

²e Matje, A. (1996), p. 1.

³e Arnold, U. (1993), pp. 20-25.

⁴e Lindner, T. (1993), pp. 8-12.

⁵e Koppelmann, U. (1996), p. 4.

⁶ e Koppelmann, U. (1996), p. 8.

⁷e Koppelmann, U. (1996), p. 8.

⁸e Hopfenbeck, W. (2000), p. 299.

⁹e Heinzl, A. (1991), pp. 6-8.

¹⁰ e Hopfenbeck, W. (2000), p. 605.

¹¹e Koppelmann, U. (1996), p. 8.

¹² e Matje A. (1996), p. 56.

¹³e Picot, A.; Dietl, H.; Franck, (1997), p. 54.

¹⁴e Matje A. (1996), p. 56.

¹⁵e Williamson, O. (1990), pp.65-70; Fischer, I. (1923), pp. 37-40.

¹⁶e Williamson, O. (1990), pp. 11-13.

¹⁷ e w.a http://www.aib.wiso.tu-muenchen.de/ lehre/ws0506/Grundlagen2/Reader-05.pdf, p. 1, as of May,16th 2006.

¹⁸e Coase, R. (1937), pp. 386-405.

¹⁹e Williamson, O. (1990), p.18.

²⁰e Bauer, C. (1990), pp. 42-44.

²¹e humann, J. (1987), pp. 212-218.

²²e Picot, A. (1993), columns 4194-4204; Koch, H. (1992), pp. 807-824.

²³e Picot, A., hneider, D., Laub, U. (1989), pp. 358-387.

²⁴e Bauer, C. (1990), pp. 12-15; Picot, A., Dietl, H., Franck, E. (1997), pp.192-195.

²⁵ e Picot, A. (1991), pp. 143-170.

²⁶e hneider, D., Zieringer, C. (1991), pp. 58-63; hneider, D. (2005), p. 84.

²⁷ e Fischer, M. (1993), pp. 248-249.

²⁸e Williamson, O. (1975), pp. 1-2.

²⁹e Williamson, O. (1975), p. 2.

³⁰e Bössmann, E. (1983), p. 107; Freese, E. (1995), p. 128.

³¹e Commons, J. (1936), pp. 237-249.

³²e Commons, J. (1936), pp. 237-249.

³³e Picot, A. (1982), pp. 268-270.

³⁴e Fuchs, W. (1994), p. 30.

³⁵e Picot, A. (1982), p. 224.

³⁶e Michaelis, E. (1985), p. 65.

³⁷ e Bössmann, E. (1983), p. 664.

³⁸e Picot, A. (1982), p. 30.

³⁹e Ebers, M., Gotsch, W. (1995), pp. 185-186.

⁴⁰e Williamson, O. (1990), p. 20.

⁴¹e Williamson, O. (1990), p. 20.

⁴²e Williamson, O. (1990), p. 21.

⁴³e Williamson, O. (1990), p. 21.

⁴⁴ e Williamson, O. (1990), p. 59.

⁴⁵e chapter 2.1.1; Ebers, M., Gotsch, W. (1995), pp. 185-186.

⁴⁶e chapter 2.1.1; Williamson, O. (1990), p. 20.

⁴⁷e Picot, A. (1982), p. 270.

⁴⁸e Kirchner, C., Picot, A. (1986), p. 63.

⁴⁹e Kern, W. (1992), column 1647.

⁵⁰e Kern, W. (1992), column 1649.

⁵¹e chapter 2.1.1.

⁵²e North, D. (1990), p. 7.

⁵³ e North, D. (1990), p. 7.

⁵⁴e chapter 2.1.1.

⁵⁵e Williamson, O. (1990), p. 22.

⁵⁶e Williamson, O. (1990), pp. 22-23.

⁵⁷e Picot, A. (1982), p. 270.

⁵⁸e Williamson, O. (1990), p. 22; Fischer, M. (1993), p. 9.

⁵⁹e Williamson, O. (1990), pp. 23-25.

⁶⁰ e Williamson, O. (1990), p. 24.

⁶¹e Williamson, O. (1990), p. 24; Fischer, M. (1993), p. 11.

⁶²e Williamson, O. (1990), p. 24; Fischer, M. (1993), p. 11.

⁶³e Williamson, O. (1990), p. 24; Fischer, M. (1993), p. 11.

⁶⁴ e Picot, A. (1982), p 270.

⁶⁵e Williamson, O. (1990), p 24; Fischer, M. (1993), p. 11.

⁶⁶e Hammes, M.; Poser, G. (1992), p. 889.

⁶⁷e Hammes, M.; Poser, G. (1992), p. 887.

⁶⁸e Hammes, M.; Poser, G. (1992), p. 887.

⁶⁹e Hammes, M.; Poser, G. (1992), p. 887.

⁷⁰e Hammes, M.; Poser, G. (1992), p. 887.

⁷¹e Williamson, O. (1989), pp. 135-182.

⁷² e Williamson, O. (1989), pp. 135-182.