Whether you are a product manufacturer, or a service organisation, as part of your business model, you need to consider what resources (or inputs) you need and how these will be sourced – what you will do yourself and what you will buy-in; and the type of relationship you will have with each of your suppliers.
There are a number of theoretical frameworks for helping you make these sourcing decisions. Two of the main ones are summarised below.
Transaction-Cost Theory (TCT) comes from a branch of economics called transaction-cost economics. According to transaction-cost theory, there are three basic alternatives for sourcing an input:
Vertical integration. You deliver the required input yourself, in-house.
Arm’s-length Relationship. You buy the input from outside, using one or more suppliers, based on best price. Any inputs required by the supplier are supplied by them or a sub-contractor. Governance relies primarily on legal contract.
Partnership or alliance. You buy the input from outside, but build a long term, cooperative relationship with your supplier. Governance relies on trust and implicit long-term agreements, rather than on legal contracts.
If a service needs to respond to a high variation in customer demand and/or use dedicated assets in the delivery of the service, then the transaction costs of doing it externally are greater than if done in-house.
In contrast, when inputs are highly standardised, or do not involve dedicated assets, the transaction costs reduce, so you have the option to use arm’s-length relationships with outside suppliers, who can specialise and achieve economies of scale.
Partnerships fall between vertical integration and arm’s-length relationships. Partnerships are preferable when gaining economies of scale is still important, but greater coordination and collaboration is required between the buyer and supplier, to handle the high customisation of inputs and/or use of dedicated assets.
Although TCT provides a useful perspective, it is also important to consider the nature of the resources themselves and how special or strategic they are. This viewpoint is the focus of another theory within economics, the Resource-based View (RBV) of the firm.
According to RBV, strategic inputs, or resources, share four characteristics. They are valuable, rare, not easily imitated, or substituted. It is these resources that give the firm its competitive advantage.
An organisation should seek to retain these strategic resources in-house. The use of an external supplier may deprive it of the competitive advantage that is derived from these resources; or make it a hostage to a third party. The latter is particularly relevant in the public sector, where outsourcing a strategic resource can expose the public sector organisation to potentially higher costs in the future, or can compromise the service being delivered.
Residential care for children in the UK
In the UK, after 20 years of outsourcing, the bulk of children’s homes are run by private companies. Only 11% of children’s homes are run by charities.
In the UK, it now costs between £200,000 and £300,000 a year for residential care for a child (2012). As a comparison, it costs £30,000 to keep someone in a low-security prison for year, and £30,000 to send someone to Eton!
As competition has reduced, prices have risen steeply and there are major issues with the quality of care. For example, companies buy homes where properties are cheapest. This can be many miles from the child’s local authority and anybody they may have known – their extended families, their teachers and their friends.
Options for local authorities are limited. They have lost both their own internal strategic capability to deliver such services themselves; and through their subsequent outsourcing decisions, any local suppliers who could help them provide a better and less costly service.
Specialisation is an extreme application of the Resource-based view of a firm. It works on the principle that productivity grows with the division of labour – a concept that goes back to the industrial revolution and Adam Smith.
Specialisation encourages organisations to outsource non-strategic activities to more specialised firms and achieve economies of scale.
But applying TCT, we can say that specialisation increases the cost of communication and coordination activities. This can result in the transaction costs being greater than if the activity had remained in-house.
Furthermore, specialisation can cause a service to become fragmented, with a subsequent negative impact on the quality and cost of the service being delivered. Overall transaction costs can actually increase, due to an increase in failure demand. Efficiency of flow is a strong argument for retaining resources in-house.
Optimising your Sourcing Strategy
In any given product or service organisation, your sourcing strategy is almost certainly going to be a mix of all three alternative sourcing options. But, it should also be remembered that increasingly, competitive advantage and entire new businesses are being forged on the creation of unique partnerships, between a mutually supporting network of suppliers and customers. These new business models take us beyond the traditional economic theories of the firm and conventional sourcing models.
In viewing your business or organisation as a system, getting the sourcing mix right is a key factor in optimising the performance of the system as a whole. Overall, the aim should be to retain in-house what is important to you as an organisation, whilst using external suppliers (of all shapes and forms) to provide additional value and create opportunities that would otherwise not exist. Beyond highly stable and standardised needs, the relationship with these suppliers should be one of close collaboration and long term partnership.
Related articles and blog posts on this site:
First Published: 9 March 2013