What Are Transaction Costs?

How Can Strategy Help Me Minimize Them?

by Mark R. Meckler, Ph.D.

The Priority of Economizing

In the words of Nobel Prize winning economist, Oliver Williamson: “between economizing and strategizing, economizing is much more fundamental” and “economizing is always the best strategy.” This is because “strategizing is relevant principally to a firm that possess market power, which are a small fraction of the total” (1991 p.75). Those of us that have ever negotiated with a distributor for the first time know that we usually don’t have much market power! Williamson, the master of TCE, argues that the benefits of economizing swamp other efforts. Economizing includes eliminating waste, reducing administrative bloat, and reducing transaction costs.

What in the World Are Transaction Costs?

We all know what waste is: using more resources than needed to get the job done and having slack resources just sitting around. Administrative bloat is all the people and policies that could go away and allow (for at least a little while) your operations to still function effectively. Time and effort spent on governance, like meetings, supervisory procedures, control systems, writing and monitoring contracts, explaining things, trying to get to the truth of the matter, disputes, conflicts—these are all transaction costs. They take time, energy and money.

One shortcut for understanding transaction costs is thinking about all the stuff and things at work about which you say: “I can ‘t believe I have to *dkdjf! deal with all this *dkdjf! stuff just to get this done.” Most of those pain in the neck things are probably transaction costs. According the TCE, economizing is about reducing inefficiency in production and reducing transaction costs. Dr. Mark Meckler says: “Looking back at my food and beverage career, whenever I was about to curse, it was usually because some critical piece of equipment just broke, or because of some transaction cost type thing that was eating up five times more time and attention than I wanted to give it.”

For the production breweries out there, if you have a salesperson on the ground in a distant market, checking accounts and visiting with your distributor on ride-a-longs, those costs are necessary to ensure that the consumers are enjoying your product in a timely manner (so the beer is fresh) and at a price that fits your production and sales strategy. The cost of that person’s mileage, their budget for giveaways and merchandise, their salary & benefits, all of the things that go into that role are ‘costs that allow you to better close the ultimate transaction’ when a consumer picks your beer over the many other choices they have at their favorite watering hole. To summarize, TCE looks at the sum of production costs (the costs to make the beer) and transaction costs (all those costs to ensure the consumer ultimately closes the transaction and picks your beer) and says reducing the sum of production and transaction costs results in ‘economizing’ and efficiency.

Like resistance in an electric wire, every single transaction cost represents another reduction from perfect efficiency and effectiveness. In fact, to the extent that there is some loss of time or effort in every single transition and hand-off in every process, there is always some cost to that loss. Sometimes beer is spilled when transferring from a fermenter to your bright tank, and other times the cost is a golf outing between your salesperson and a key account manager. These are called transaction costs and they all add up. Williamson taught us the fundamental goal of any firms is to reduce these costs – to economize (1991). In fact it is his opinion (and he did win the 2009 Nobel Prize for economics) that business organizations are fundamentally transaction cost economizers. The reason firms exist, and the reason firms constantly change their sizes and structures is because managers are constantly trying to reduce the sum of production and transaction costs (Williamson, 1975). Let’s use an example to make this clear.

So then, what is TCE “Strategy”

The reason TCE is discussed among strategists and not just management experts, or operations management employees, is that there is a strategic approach to ‘economizing’. It’s really quite simple. As a general rule, decide what you farm out (outsource) to others in the value chain and what you do yourself (in-house) by whichever approach minimizes transaction costs. Strategists call this the “Make vs. Buy” decision.

For example, supposed you brew about 3,000 barrels of beer per year and sell over 75% off premise through a distributor. From the launch of your company up to about 3,000 barrels, you may not be able to afford your own bottling or canning line, so you outsource this to a mobile bottler. That company makes good money by having efficient bottling equipment and you pay them to transfer your beer into bottles without spilling much. Thus, you are outsourcing the packaging process of your beer, which increases the transaction costs of selling your beer, especially versus the beer you sell over the counter in your tasting room. However, the mobile bottler is cheaper than buying the bottling equipment yourself. Initially, it may be cheaper to outsource because you can’t get a bank loan large enough to buy your own equipment. Later on, you may wish to buy new fermentation tanks or a larger brewhouse with your extra money, so the added transaction cost of outsourcing packaging is still ‘cheaper’ when you consider all the myriad of things you are spending money on in your business. After a while, perhaps once your new brewhouse and fermenters come online and you can make, say 8,000 barrels per year, you decide to buy your own bottling line. At this point, instead of paying the mobile bottler to package your beer, it might be cheaper to invest that extra transaction cost into a new bottling line that you now own in-house. This is a shift in the structure of your company, because it is now ‘cheaper’ to finance your own bottling line and ‘pay yourself’ to package your beer. Since you now have a much higher production capacity, it will actually cost more to use the mobile bottler, and it would be cheaper to finance your own bottling line and pay interest on a loan, than to outsource to the mobile guys. You must always be re-evaluating and economizing as your business changes and grows. That is the strategic use of economizing.

From the perspective of economizing, every make-buy decision should be informed by this rule. If bottling vendors are raising prices and becoming too expensive, and it’s a complete pain in the neck time-wise and cost-wise, then integrate that function: bring it in-house and do it yourself to minimize the transaction costs. If it’s a complete pain in the neck to do your own bookkeeping and payroll and you are spending all your valuable time and mental capacity on that, then reduce those transaction costs by dis-integrating that function: outsource bookkeeping and payroll. Later on, when your company grows and you can afford a full time controller or CFO, then you can bring bookkeeping and payroll back in-house.

References

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Collis, D. J., & Montgomery, C. A. (1995). Competing on resources: Strategy in the 1990s.73, 118.

Porter, M. E. (1980). Competitive strategy: Techniques for analyzing industries and competitors. New York: Free Press.

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Williamson, O. E. (1991). Strategizing, economizing, and economic organization. Strategic Management Journal, 12(S2), 75-94.

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