Transaction Cost Economics of the Source-to-Pay Process
The view on procurement from the perspective of traditional economic theories
Nowadays, procurement increasingly speaks up about its critical role in the firm's very existence.
Despite this being true for many companies, we're mainly trying to create awareness instead of claiming our well-deserved place in the company ranks.
In fact, the importance of procurement was confirmed many decades ago upon the formulation of some classical economic theories.
Here's the one for you - the Transaction Cost Theory applied to the Source-to-Pay process.
The Economic Theory of the Firm
In fact, the Theory of the Firm is the portfolio of theories attempting to explain why some firms prosper in the market and some don't, why there are different firms in the market and not a single huge one, and how firms identify the consumer need and successfully satisfy it.
We explained some of them in our earlier posts, especially in this deep dive into different aspects of outsourcing.
Transaction Cost Economics
Transaction Costs Economics (TCE) looks into why some firms acquire goods or services from the market, others decide to insource, and the rest form alliances.
TCE introduces the notion of the transaction cost - the cost of economic exchange between the market actors. It is the unit of commercial relationships, enabling coordination between firms in the market and inside the firm itself.
This theory assumes that the firms attempt to minimize the transaction cost by selecting the best possible governance, which mitigates risks present in the exchange.
Let's decompose this definition.
Types of governance
The governance is the regulatory regime that guides the economic exchange. It could be of three possible types:
- vertical or hierarchical one, where transactions are internalized within the firm;
- market one, where transaction cost is affected by the competition and goods or services sourced from the open market;
- Hybrid one, where various types of partnerships are formed - alliances, cooperatives, even long-term strategic agreements.
In simple terms, those governance types correspond to business-critical decisions - "make", "buy", or "partner", respectively.
Risks of economic exchange
Unlike Neoclassical Theory, which also forms the Theory of the Firm, TCE suggests that market actors aren't perfectly rational in their decisions. Therefore, they are subjected to cognitive and resource limitations and are satisficing, i.e., seeking "good enough" decisions.
TCE follows the Bounded Rationality theory, which we also described in our earlier posts. It also assumes that firms could be inclined to opportunism, i.e., "self-interest seeking with guile."
Therefore, parties to the economic exchange may seek to take advantage of each other, and bounded rationality would prevent them from including all relevant contingencies in their contracts.
Types of transaction costs
Finally, as the firms are concerned with transaction costs, they will be looking into minimizing:
- Search and information costs arising from finding a capable supplier of goods or services;
- Bargaining costs of negotiating the best deal;
- Policing and enforcement costs related to drawing up the comprehensive contract and ensuring compliance with its terms and conditions.
The source-to-pay process from the TCE perspective
Considering the Transaction Cost Economics postulates, we should look at the source-to-pay (S2P) process differently.
As many companies still suggest, it isn't just the way to find the lowest bid.
S2P is the core process that enables the success of the business.
It minimizes the transaction cost, selects the appropriate form of governance, and mitigates the risks.
How to minimize transaction costs in the S2P process
There are practical tools and techniques to reduce transaction costs at different stages of the S2P process.
As suggested in the slide above, SRM, e-procurement, and online buying could offer diverse solutions.
We explained some of those in more detail, e.g., relational contracts, B2B marketplaces, buying channels.
By all means, this list isn't exhaustive. The critical task of the procurement professional is to take advantage of tools and technologies to make the S2P process the source of business value and an enabler of the competitive advantage.
Classical economic theories clearly support our ambitions to identify procurement among the firm's vital functions. This knowledge has been out there for decades, and it's up for grabs by those who step beyond the low-bid arena.
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More information on this and other exciting topics can be found in "The Technology Procurement Handbook." It represents 23 years of experience, billions of dollars worth of successful sourcing projects, and 1000s of hours spent on research, analysis, and content creation for the most demanding professional readers.
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