The Effects of Production Costs and Transaction Costs on the Degree of Vertical (De)Integration

Abstract

A fundamental decision that confronts companies in designing organizational structure is to determine which tasks to perform in-house and which to contract to outside agencies through alliances andpartnerships. Interorganizational transactions can be managed using alternative governance mechanisms ranging from markets (independence) to hierarchies (integration). Transaction cost analysis advocates the selection of that governance mode that minimizes the sum of transaction costs and production costs. Though transaction costs have been studied in considerable detail in marketing, the analysis of production costs has been limited. This paper argues that while transaction cost economizing is important, such economizing cannot proceed regardless of production cost ramifications. Transaction cost economizing needs to be located within a larger economizing framework, and the resultant trade-offs between transaction and production costs need to be recognized. Further, this paper posits that the selection of governance modes by a firm are mediated by strategic considerations as well. Any normative implications for designing governance structures should thus be driven by analyzing transaction costs, production costs, and strategic considerations. THE EFFECTS OF PRODUCTION COSTS AND TRANSACTION COSTS ON THE DEGREE OF VERTICAL (DE)INTEGRATION Firms competing in rapidly changing markets face extremely short cycles to develop and market their products and services. The need for such rapid development and marketing actions challenges a firm’s ability to champion the entire process by itself, and increasingly firms are being forced to look for alternative mechanisms like forming alliances and partnerships to facilitate and ensure speed. A fundamental decision, then, that confronts companies in designing organizational structure is to determine which tasks to perform in-house and which to contract to outside agencies through joint actions like alliances or partnerships. Companies face this choice in structuring both their sources ofsupply and their downstream intermediaries through which they distribute their products. Interorganizational transactions can be managed using alternative governance mechanisms ranging from markets (independence) to hierarchies (integration). Transaction cost analysis theory advocates the selection of the governance mode that minimizes the sum of transaction costs and production costs. Most research in marketing, interorganizational relationships, and strategy have emphasized the analysis of transaction costs and derived normative implications for designing contractual modes where transactions are internalized through vertical integration to minimize transaction costs (e.g., Anderson 1985, Monteverde and Teece 1982). The analysis of production costs has, however, been limited. Where production costs have been considered, their analysis has been restricted to the manner in which they are affectedby such factors as firm size, the in-house presence of resources necessary for internalization, and scale economy requirements. This is unfortunate. As Williamson (1981) notes, while transaction cost economizing is important, such economizing cannot proceed regardless of production cost ramifications. Thus the analysis of transaction cost should be located within a larger economizing framework, and the resultant trade-offs between transaction and production costs need to be recognized. In this paper we stress the importance of production costs in designing appropriate governance modes. We argue that in addition to size, scale, and resource considerations, production costs are influenced by the need for shorter response times, amount of experience, and control loss in a hierarchy. Besides, when decisions of structuring governance modes are made, the likelihood ofusing production cost imperatives relative to transaction cost imperatives is affected by the measurability of these two costs. While the need to minimize transaction costs leads a firm to internalize transactions by adopting integrated governance modes, the lateral shift from a market mediated mechanism to a hierarchically structured mode strains production costs. When production costs are high, market mediated governance modes become more attractive relative to vertical integration. The simultaneous variation of transaction and production costs with governance modes occurs as follows: Markets Hierarchies increasing production costs decreasing transaction costs The efforts to minimize transaction costs thus tend to increase production costs, and vice versa. The sum of transaction costs and production costs can be jointly minimized by adopting hybrid structures that include partially integrated governance modes. Several companies are