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Lect 2 Sourcing Decisions & Microeconomics
Lect 2 Sourcing Decisions & Microeconomics
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
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:
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.
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
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.
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.