Welcome

Strategies of Network Companies

Jonathan D. Warehamwareham@acm.org

What we will study…

Transaction Cost Economics Virtual Companies &

formation of firm boundaries

Economic Theory: Boundary of the firm

Agents

Firms

Networks

Markets

A Virtual Firm

Sun Microsystems, a leading maker of computer workstations, concentrates on hardware and software design, where it distinguished itself from competitors, and outsources nearly everything else in its value chain

It relies so heavily on external manufacturers and distributors that its own employees never touch one of its top selling products

After a vendor assembles the machine, another contract supplier delivers it to the customer

Sun Microsystems, Inc.

Virtual Designs

In a Virtual Corporation,...:"...the majority of the activities of the firm

are contracted or outsourced."

This allows the firm to focus on its strategic, core processes (core competencies)

Strategic alliances.....

Economic Paradox

In 1958 the Harvard Business Revenue predicted that computers would lead to a greater concentration of power in American business because they would allow bosses to keep better track of information within large firms. Eventually, it predicted that the economy would be dominated by a few giants. In 1967 economist J.K. Galbraith argued that new technology would inevitably lead to increasing dominance by big corporations immune to market forces.

These predictions have turned out wrong: the average size of firms has shrunk and competition has decreased since 1960’s. Recent research suggests that the economy is beginning a transition from large, vertically integrated enterprises to organizational forms that draw on resources of small, independent specialists suppliers. For example, in a study of 549 large firms, increased use of IT has found to be associated with substantial decreases in firm size and diversification.

The Manager’s role

Procure inputs in the least cost manner

Provide incentives for workers to put forth effort

Failure to accomplish this results in a point like A

$100

80

$100Output

Costs

A

B

C(Q)

Methods of Procuring Inputs

Spot Exchange When the buyer and seller of an input

meet, exchange, and then go their separate ways.

Contracts A legal document that creates an extended

relationship between a buyer and a seller. Vertical Integration

When a firm shuns other suppliers and chooses to produce an input internally.

Knight (1921) & Coase (1937)

Coase (1937) Why do we have firms?

Knight (1921) Why don’t we have one big firm?

possibility of monopoly rents motivates continuous and unlimited expansion of firms, But we do not always see it. There must be offsetting mechanisms.

Ronald Coase (1937)

Why do we have firms?

there must be some cost in using the price mechanism.

• Price discovery/search costs• Contract negotiation• Long term stability of supply sources

(uncertainty)

Ergo, operation of the market costs something, and by forming and organization and letting some authority to allocate resources, some costs are saved

Coase’s Argument

Transactions vary in nature and dimension, and will align themselves with the governance mechanisms which manages these transactions most efficiently.

Size of firm increases until additional rent gained by bringing transaction in house is superceded by cost of bringing it in. That is, it has to be more costly on the market

Coase theorem: Efficiency determines organizational structure

Coordination Costs

Price determination Details of transaction Disclose existence of buyers and

sellers to execute transactions Search prices or quality control Compiling and transferring

information

Basic attributes of transactions

Specificity Frequency Duration Complexity Uncertainty Difficulty of measuring performance Connectedness

Asset Specificity

Investments made to allow two parties to exchange but has little or no value outside of the exchange relationship

Site specificity Physical-asset specificity Dedicated assets Human capital Lead to higher transaction costs and

the problem of “hold-up”

Rule of thumb

Substantial specialized investments relative to contracting costs?

Spot ExchangeNo

Complex contracting environment relative to costs of integration?

Yes

Vertical Integration

Yes

Contract

No

Coordination Costs

Price determination Details of transaction Disclose existence of buyers and

sellers to execute transactions Search prices or quality control Compiling and transferring information

Basic attributes of transactions

Specificity Frequency Duration Complexity Uncertainty Difficulty of measuring performance Connectedness

Specificity & Frequency

Standard Medium High

Standard Equipment Customized Equipment Constructing a plantOccasional Machinery, PCs, Automobiles Machinery requiring some custom config. Turn-key projects

Markets Company to company negotiation Company to company negotiation

Frequency Once off negotiated transaction Semi-complex contracts Very complex contracts/government regulation

Standard Raw Material Customized Material Value adding processes as specific site

Frequent Sugar, RAM chips, Steel Raw mat. with special process unique to customerproduction processes within one or several

factories within same location/proximity

Markets Joint ventures, transfer of equity HierarchiesContracts short to medium term Long-term binding contracts with Internal integration/ vertical conglomerate

I year supplier: price based on index significant investment

Specificity

Your Mission

You are a principal in a high tech start-up with 70m in funding and a rapidly growing customer base. Your business model has been tested in several pilot markets and the board has given the green light to scale up from 2 to 10 markets. This will make significant scalability demands of your IT function that, up to now, you have grown internally. At a management meeting, the chairman asks:

“ What do you recommend?“

Your Task

Use the tools provided by TCE to evaluate the following alternatives:

1. Full outsourcing2. Partial outsourcing (specify what

functions)3. Internal integration

Consider these factors

1. Specificity2. Frequency3. Duration 4. Complexity 5. Uncertainty 6. Performance measurement7. Connectedness8. Search Costs9. Price Determination 10.Quality Monitoring

Market

Hierarchy

Asset specificityAsset specificity

Pro

du

ct C

om

ple

xit

yPro

du

ct C

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ple

xit

y

IT, Complexity & Specificity

Outsourcers: Who?

Computer Associates

Peachtree Software

Microsof

t

EDS

IBM Global Solutions

Arthur Anderson

IBM

US Robotics

Dell

Index

Ceridian

Primavera

Mom &

Pop

Consulting

Equifax

Lotus

HP

Bell South

MCI

AT&T

Compaq

Factors Favoring Outsourcing

Managers can and should make use of two kinds of arguments in their case for (or against) outsourcing (bandwagon reasoning is not a defensible managerial decision!)

Need for organizations to focus on their strategic assets or core competencies

Realization of greater economies (lower costs)

Need for greater flexibility and expertise in workforce

Financial

arguments

Non-Financial

arguments

Given a positive financial assessment:

Consider In-house Bids vs.

Outsourcer BidsMost Likely to

Outsource

Retain In-houseIf Outsource,

Legal Protections

Critical

A Core Competency/ Strategic Asset?

No

Yes

Does Firm Have Internal Expertise?

NoYes

Is the Web system or service being considered.....

Outsourcing & Virtual design

A tale of 2 companies….

Sell 50,000 computers with only 4 days of inventory

Keep few suppliers very close 30 suppliers 75% of materials When order is made, signal is sent to

supplier, 90 minutes later, supplies are delivered to Dell.

“We sell what we have, we don´t sell what we don´t have”

Dell From HBR

Have as few suppliers as possible In real time, communicate your

inventory levels and replenishment needs to them

Order from suppliers only when you receive demand from customers.

By going direct; no Channel Push

Manufacturers

Wholesalers/Distributors

VARS

End Users

Avoiding the Risks… Assets & Inventory Accounts receivable Use technology to bring benefits of

vertical coordination to the network

Darling of stock market. First Virtual company No inventory, no warehouses But what happened…..

Bringing vertical coordination to the network… but how?

3,500 modular parts30+ suppliers

Over 1 million products, many suppliers

Market

Hierarchy

Asset specificityAsset specificity

Pro

du

ct C

om

ple

xit

yPro

du

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IT, Complexity & Specificity