Managerial Economics: Assignment
In this paper we shall focus first on the key characteristics of TCE (transactions cost economics) giving a theoretical introduction of its concepts. We will then analyze the vertical boundaries of Ross & C, the company I currently work for, and we will see how they evolved during the years. The discussion will concern the “to buy or to make” dilemma applied to the real case of the sales force. We will in fact show the transition from the sale force as outside agents (to buy) to the sale force as direct employee (to make) showing how the change of the environment can influence the modus operandi of a company.
Key characteristics of Transactions Costs Economics (TCE) Transactions costs economics (TCE) theory, introduced by R. Coese in 1937 and later developed by Williamson, is concerned with understanding when it’s preferable to perform a process within the company (vertical integration) or on the contrary when it is convenient going to the market. According to Williamson (1979) “the three critical dimensions for characterizing transactions are (1) uncertainty, (2) the frequency with which transactions recur, and (3) the degree to which durable transaction-specific investments are incurred. The consequent transaction costs are normally generated by researching potential suppliers, comparing the cost of the supplier and negotiating contracts. Further, costs will come from monitoring the performance and, in some cases, from legal costs due to contractual breaches. The effectiveness of contracts hence depends on the completeness of the contract and the available body of contract law (Besanko – 2010) In the real world most of the contracts are imperfect due to the impossibility to map every possible contingency.
The main factors that prevent complete contracting are: (1)bound rationality (2)difficulties measuring performance (3)asymmetric information, Firstly, bound rationality considers the limited capacity of individuals of keeping under control all the contingencies that could incur in a transaction. Such uncertainty can arise either due to lack or excess of information. Secondly, difficulty measuring performance concerns the fact that in certain cases the measure of the performance is not easy and unique.
This problem can lead to confusion into each party’s rights and responsibilities. Lastly, asymmetric information refers to the case when one party has more or better information than the other having then the possibility to alter or disguise the result of an activity to its best advantage. However, in taking the final decision, we should keep in mind also other two factors: the (4) relationship-specific assets and (5) holdup problems. A relationship-specific asset is an investment made to support a given transaction (Besanko – 2010).
The suppliers with relationship-specific asset generally have qualified capacities to conduct the transaction and, due to this specific ability hard to substitute, can become opportunistic or unadoptable with the firms. Asset specificity can be identified in: (1) Site specificity. Site specificity occurs when investments in productive assets are made in close physical proximity to each other in order to reduce inventory, transportation, and sometimes processing costs. (2) Physical Asset specificity. Equipment and machinery specific to a particular customer or are specialized to use an input of a particular supplier.
For instance, the giant presses for stamping out automobile body parts are specific to the automobile manufacturer. (3) Dedicated Assets. Dedicated assets by an input supplier are investments in general capital to meet the demand of a specific buyer, for example the military defence equipment. (4) Human-Asset Specificity. Human-asset specificity refers to the accumulation of knowledge and expertise that is specific to one organization as the design engineers who have developed special skills in designing a particular type of automotive.
Eventually, the holdup problems concern the case when a firm is in the position to renegotiate the terms of a contract. In such situation, if the contract is incomplete, the firm can revise the parameters of the deal reducing for example the price per unit that the company is willing to pay to its supplier. The inevitable consequences of the holdup problems are (1) more difficult contract negotiations and more frequent renegotiations, (2) distrust and (3) reduced investment in relationship-specific investments (Besanko – 2010). Vertical integration and outsourcing: the case of the sales network in PT Ross & C Indonesia.
In this section we will analyze the make or buy dilemma in the sales network of the company I currently work for, Ross & C Asia wood division, a subsidiary of Ross & C Group. The case will then focus only on the selling area of Indonesia explaining when it is preferable to operate with direct sales (to make) rather than with sales reps (to buy) and how these choices depend on the environment and its changes. Brief introduction of Ross & C Group Ross & C Group is an Italian company manufacturing machines and integrated systems for processing wood, glass and stone.
The company can offer several solutions that range from the design of complete lines for large furniture firms to single machines for small-medium companies. Ross & C Group is a multinational entity marketing its products thanks to a network of subsidiaries and branch offices located in strategic markets. The main Ross & C Wood customers are furniture manufacturing industries which can sell the products (complete furniture or furniture in components) directly to the final user or through other furniture industries (resellers).
From this quick introduction, it is clear that Ross & C operates in the machines manufacturing industry where the after sales service plays a crucial part also in the promotion and sales activity. Due to the importance of the after-sales service and because of its innovative technology, in 1992 Ross & C decided to establish a subsidiary in Jakarta, Ross & C Indonesia, mainly for supporting the service activities of local agents and dealers. At that time, in fact, the sales were entrusted to local representatives that didn’t have the proper knowledge and skill to maintain the Ross & C equipments.
Agents are normally sales reps promoting a wide range of products but with no possibility to offer after-sales service; dealers have instead their own technical staff able provide service assistance. In order to understand the choice of Ross & C to go to the market (to buy), it would be useful to give a brief analysis of the environment the company was operating in. (1) Cultural differences. At the time (1992) of starting the activity in Jakarta, Ross & C was an Italian company with no experience of the Indonesian habits and styles.
Therefore it needed local staff to approach and scan effectively the market. (2) Long term relationships and non-selling activities. As matter of fact, in Asia the success of a deal depends strongly on trust and non selling activities as for example dinners, karaoke and spare time spent with the customers. A new salesperson would have required longer time to build and enforce these relationships. (3) Legal and credit system. The legal and credit system was not sufficiently safe for a foreign company.
Normally the local dealers, due to their knowledge of the customers’ financial health, could afford the risk to allow installments payments. Under these conditions, Ross & C did start operating in Indonesia cooperating with three local dealers, two covering Jakarta Area and one Surabaya. Taking advantage of being one of the few players in the market, Ross & C was in the position to negotiate the commissions at its advantage. Also the control on the dealers was not too difficult thanks to the fact that the dealers were depending on Ross & C for the after sales service.
The above scenario evolved with the entry of other competitors in the woodworking machinery market. Starting from year 2005, the Asian competitors, especially from China and Taiwan, have been able to reduce the technological gap with the European brands starting manufacturing CNC (numerical control centers) and edgebanding machines with similar features at a more competitive price. In such situation Ross & C did start suffering several problems. (1) Firstly an increased specific asset of the dealers with consequent holdup issues.
Due to the long presence in the market and thanks to their reliability and competence developed during the years, the dealers were now able to completely assist the customers without the support of Ross & C’s service offering in addition a list of complementary products as for example glue, tools and hardware. Furthermore, the new Asian players presented the double advantage for the dealers to (a) offer cheaper and so more sellable products and (b) to earn more commissions.
Leveraging on the fact of their strength in the market (specific asset) and thanks to the opportunity to earn more commissions, the reps were able to holdup Ross & C. At that point in fact they were in the position to negotiate the commissions more effectively and decide if to support Ross & C or not. (2) Another problem was arising: the difficulty of evaluating the performances. As a common agency problem, dealers rarely share their customers’ database and almost never pass the complete information regarding the selling meetings.
In the new scenario it was then harder for the principal (Ross & C) to evaluate the effectiveness of the agents and the only use of commissions couldn’t detect hidden actions or hidden signals. For example Ross & C was not in the position to control if the agents were promoting Chinese products neither the amount of time they were investing in Ross & C brand. The result was an inevitable loss of coordination and fall of sales. At that point the management had to take a decision, to continue to work through the market giving more commissions to the dealers, reducing the profitability, or start selling directly.
On the other hand, as mentioned by Anderson and Coughlan (1987) “When this ability is diminished, for whatever reason, the impetus to integrate is increased”. From a quick sales analysis, it came out that 70% of Ross & C market was concentrated in Jakarta area, while the remaining zones (Surabaya, Semarang and Medan) were constituting only 30% of the incoming sales (Ross & C Asia – 2008). This evidence, the changed scenario and the fact that Ross & C could benefit of a good reputation thanks to its after sales actions during the years, convinced the management to opt for the direct sales, at least in Jakarta.
Finally in 2007 the solution was to employ a local agent (vertical integration) in Jakarta area and to continue the sales through local dealers/agents in the other areas (Surabaya, Semarang, Medan) only for certain products where there was still the mutual interest to collaborate. The choice of employing a local agent with long previous experience brought to several advantages. (1)A more efficient and constant marketing activity. Being directly employed, the salesman is now fully concentrated only on Ross & C products. 2)An easier and more effective control of the sales activities as a result of regular communication with the employee. (3)Enforcement of direct trust in Ross & C brand removing the previous filter interposed by the dealers. (4)Possibility to allow installment payments thanks to the long term relationship of the employer with the customers. In conclusion we have seen how the company changed its strategy in approaching the sales distribution according to the changes in the market and how the “to buy” or “to make” dilemma has evolved during the years.
In the beginning, Ross & C preferred going to the market. It didn’t have enough knowledge of the territory but it used its technologic advantage to control the local existing sale network. With the entry of other competitors and loss of technical supremacy it was forced to review its position. The significant relationship-specific assets and coordination problems did lead the company to vertical integration with the employment of a direct salesman. Ultimately we can say that the environment is in continuous mutation and any future choice will depend on its changes.
If for example Ross & C will be able to offer a new innovative and unique product, most probably the barriers that we have seen before will be eliminated and the use of the market will be possible again. Besanko, David (2010) – ‘Economics of Strategy’, Erin Anderson (1985) – ‘The Salesperson as outside Agent or Employee: A Transaction Cost Analysis’ – Marketing Science, Vol. 4, No. 3, pp. 234-254 Erin Anderson and Anne T. Coughlan (1987) – ‘International Market Entry and Expansion Via Independent or Integrated Channels of Distribution’ – The Journal of Marketing, Vol. 51, No. 1, pp. 71-82
