Analyst Outlook: The new cost of doing business

We are on the verge of a broad systematic reduction of transaction costs throughout the world economy. But this isn’t breaking news to most CIOs. By the very nature of their job they are aware of the trend to outsource all but the most core specialization of their businesses.

However, research shows their business counterparts still need some assistance in reconciling a frictionless economy with their own corporate future.

Interbusiness relationships: the fabric of any business

Does your business make its own ketchup? Do its own cleaning? If it’s like most others, the answer is no.

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If you want to prepare food commercially, and not poison anyone as a consequence, you need to have a clean kitchen and some skilled people that know all about hygiene. Similarly, for office cleaning, why bother to employ your own cleaners when there are firms to do this for you?

Not making ketchup or cleaning offices is part of a larger trend in business that sees management focusing their attention and resources on key activities and looking to other firms to provide the rest.

Why is this happening? There are several different reasons that influence why firms do what they do and why they choose to outsource other things. The real breakthrough in thinking about this came from an economist, Ronald Coase, who finally got his Nobel Prize in economics in 1991 for a paper he wrote in 1937 (never let it be said that economists are a hasty bunch).

Coase wrote that firms are what they are because of transaction costs. To Coase, a transaction cost meant more than just the invoice price. To him it was a combination of the administration cost (invoicing, payment costs and so on) plus something called the “information cost” – the cost of locating a supplier, finding out all about a product, and then deciding on how much to pay for it.

For example, suppose you want to buy an electronic hockey game. You might try a few specialist retailers to see who sells them and what the various models are like. At the end of the transaction, in addition to the cost of the game itself you have to add the cost of travelling around to the shops doing your research. In some circumstances, the value of this ‘travelling around’ cost can far exceed the purchase price of the item itself.

Now think about what IT does: browsing and buying online slashes transaction costs.

One company, one specialization

Looking to the future this will likely mean businesses will focus on being good at one of three things: customer intimacy (knowing your customer very well and being known equally by them), operational excellence (being a low-cost high-quality producer), or innovation, (being able to produce a stream of new products that can be premium priced).

Each strategy requires a different pattern of investments. If you are into customer intimacy you need a breadth of product and a deep understanding of customer-relationship systems. If you are into enterprise excellence you need to invest heavily into logistics. If you are into innovation you need a nimble organization with good knowledge-management systems.

The point is, if you are investing, you can only really invest heavily in one of three things, not everything at once.

High transaction costs are currently binding organizations together so they are jacks of all trades. IT will unravel this. As the IT revolution continues, businesses will increase their scale as they reach out to more markets while at the same time diminishing the scope of what they do as they make greater use of business partners.

When next you decide not to make your own ketchup or clean your own office, remember you are part of a much bigger trend where falling transaction cost, thanks to IT, is changing the business environment.

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–Andrew Rowsell-Jones is vice president and research director for Gartner’s CIO Executive Programs.

Related links:

CIO survey: IT spending projections on the rise

Cost savings here can incur cost hikes there

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