Sunday, January 6, 2008

Outsourcing and Transaction costs; The West’s Achilles heel?

Today the value chain in a typical business has become riddled with transactions due to outsourcing.

Product is transferred from raw material provider through the outsourced value chain to the end customer.

Each of those transfers generate transactions such as ordering, shipping, billing, receiving, customs clearing, settling and so forth.

A simple transaction such as billing triggers a number of multiple transactions.
On the shipper’s side, generating an invoice, booking the sale, delivering the invoice, receiving the payment, booking the payment and so forth, and on the receivers side, receiving the invoice, registering the invoice, receiving the goods, booking the receipt goods, generating a payment and so on.

I can mention many more transactions but you get the idea.

So with the advent of outsourcing, as the number of functions outsourced increases, so do the number of transactions multiply because each of the outsourcers will perform al these necessary reciprocal functions which generate transactions and the costs associated with them.

A traditional value chain used to consist of, for example, a supplier of raw materials, a manufacturer, a wholesaler and a retailer each generating a number of transactions as the product gets transferred from one to the other. Today each of the players in this value chain will have a number of its own internal processes outsourced, thus generating more transactions as they do so.

As more is outsourced, more transactions are generated.

Current studies indicate that up to 70% of the cost of a product in a long value-chain are transaction costs (see the purple shaded area in the chart above). This is an enormous slice of the pie that some competitor inevitably will be able to take a bite out of if he/she solves the issue of transaction costs and either reduces the costs considerably or takes many of them out altogether.

The dominant factor in global trade is Transaction cost not Labor Cost.

A reduction in the transaction costs is where the greatest damage can be done to the West’s economies and where it is most vulnerable, a veritable Achilles’ heel.

So how do you reduce the transaction costs in this equation?

Ensure that your transaction costs are the lowest in the current environment through increased investment in Information Technology thus maintaining a sufficiently steep barrier to entry for any competitor.

Reduce your existing transaction costs by outsourcing transaction processing to a Subject Matter Expert (SME), whose critical mass and expertise ensures a reduction in these costs.

Shorten the value chain by vertical integration and thus eliminate most of the external transactions generated by outsourcing.

One part of the solution is to have superior and efficient Information Technology that reduces the costs of these transactions thereby keeping them lower than your competition, making it difficult for them to compete.
A perfect example of a company that understands the basics of information warfare is Wal-Mart and the way it uses information technology as a weapon. Its competitors are unable to match its transaction costs. Wal-Mart has other cost advantages such as, huge volume/critical mass, its own distribution system and so on.

Due to its enormous investment in IT and the lead it has in information management the threat to the West is relatively low in the short run, however they must maintain their technological edge in information management in order to avoid becoming vulnerable in this race. Many emerging economies are rapidly ramping up to come to do battle with the Western economies in this area.

Smaller companies with high transaction costs and not enough capital to invest or insufficient critical mass should be scrambling to outsource their Information Technology and Business Processes to an SME. With their superior system integration skills and critical mass these SME’s will reduce their customers’ transaction costs.

Another option is to eliminate the number of transactions involved in the value chain through vertical integration and by eliminating a number of links in the chain. An attack like this is much harder to defend against as it takes considerably less investment than maintaining a superior Information Technology infrastructure. This is the real threat to the dominance of the West.

The internet has always been a threat to some players in the value chain and will continue to be a real leveler of the playing field as technology improves its performance and more and more people start gaining confidence in performing transactions over the web.

The internet has taken out many middlemen that used to be in the value chain and has started with the retailer. Look at what happened to the travel agencies, Travelocity,, Expedia have all taken an enormous chunk of business away from the traditional Travel Agent. That is just on the retail end. Phase two is already underway. There is a threat to that model with the arrival of YTB and various other turnkey secure hosted travel portals where the end consumer is the travel agent.

When have you last ordered Anti Virus software in a shop, or Adobe Acrobat software, or Microsoft software and upgrades or for that matter car insurance from Geico? What I am trying to say is that selling on the internet through internet storefronts is already a reality.

Now, once these contract manufacturers from China and India and other emerging countries move up in the value chain and are able to bring the products, they currently manufacture so cheaply on an outsourced basis, directly to the consumers through vertical integration by acquiring distributors or a mail order houses in the West, God help us.

So what does this mean?

Information Technology should be used as a weapon in Information warfare. We must become system integrators encompassing the entire value chain. IT budgets should increase not decrease and should be based on its effect on the entire value chain. CIO’s must view themselves and become enterprise economists not just corporate CIO’s.

Optimize other phases and disciplines in the value chain, as competitive advantage is provided by many factors, business processes, volume or critical mass, distribution techniques, utilizing the Internet, as demonstrated in the Wal-Mart example.

The winner of Information Warfare will be the entity that understands that Information Technology is the weapon of choice and is capable of integrating the information that encompasses their entire value chain.

Transaction Costs must be reduced to the point where they are equal or less than those of a vertically integrated value chain, or else the ability for emerging countries to beat the West to the consumer through vertical integration with lower transaction costs and lower prices will become a reality in the long run.