In their analysis of how the Internet has impacted transaction costs, Larry Downes
and Chunka Mui extended the transaction cost analysis of British economist Ronald
Coase. Their conclusion:
As transaction costs diminish, smaller organizations evolve.
This observation will be identified as the Third Law of Techonomics:
The Law of Diminishing Organization Size.
As technology has supplied more and more “perfect
information,” reducing transaction costs and risks, it has become easier to outsource
more of an organization’s work to efficient and reliable sources, reducing
the need for internal company employment.
Let us go back to the phrase “transaction cost analysis.” Ronald Coase first
described this kind of analysis in a 1937 article entitled “The Nature of the Firm.”
In layman’s terms, transaction cost analysis is simply the make-or-buy decision.
Should I make a needed product or buy it from some external source? As individual
consumers of goods, we perform these make-or-buy decisions many times daily,
usually opting to buy more often than make, as our lives become more mutually
dependant. Corporations, likewise, continually analyze make-or-buy transactions in
order to compete economically in the free market. Coase found that many elements go into transaction analysis once a need is determined.
• Availability
• Quality
• Transport
• Punctuality
• Inventory
• Switching
• Risk
• Availability
• Quality
• Reliability
• Price
• Trust
Every day, people all over the world exchange their time for money and their
money for needed commodities. Each generation makes these decisions differently,
based on their skills, the availability of needed products, and the demands on their
time. The last 200 years in the U.S. have witnessed a huge shift in personal outsourcing
as we have moved from an agrarian society to an industrial one.
Coase studied several U.S. companies in the early 1930s. In particular at Ford
Motor Company’s River Rouge Plant, he found a monolithic (self-contained) factory
that turned iron ore into automobiles. Since Ford had pioneered mass manufacturing,
obtaining parts in the quantities needed to meet production was hard to do. He was
forced to make, rather than buy, many components.
The automobile industry in America went mostly with the make option for many
years, even though buy options were arising. If you follow the industry’s progress
through the years, you see a major shift in structural organization occurring in the
1970s. This had a lot do with the Japanese, who used outsourcing effectively to
improve quality and reduce costs simultaneously. The entire industry has now followed
suit in order to compete in the international marketplace.
If you look at the contributing factors to the make-or-buy decision, you will see
that many of them are rooted in information. The better the information, the more
accessible the information, the more timely the information, the easier it is to make
a justifiable value judgment to make or buy. More information leads to awareness
of more options.
Consider again the automobile maker. In the 1930s, there may have been only
one or two bearing makers to provide quality wheel bearings in the quantities needed
for mass-producing automobiles; same for transmissions, windshield glass, headlights,
etc. An automobile manufacturer would find a key supplier (if any), determine
price possibilities, and then decide whether to do the job inside or farm it out. The
decision was often to do the job within the company.
Now fast forward to the 1990s. The Internet is introduced. Automation and mass
manufacturing have become widely practiced skills. Virtually every component on
an automobile can be made in the quantities needed by a dozen or more suppliers.
Now the Internet provides a means to find these multiple sources, monitor their work
product, simultaneously pit them against each other to supply the same product,
switch seamlessly from one supplier to another, and transact all the financial arrangements
to the benefit of the buyer. No surprise that the make-or-buy pendulum has
swung far to the buy side. This is also true on our personal endeavors as we become
more consumer-driven and interdependent.
If organizations are getting smaller due to outsourcing many jobs previously
done “in house,” does this mean that jobs are dwindling away? Not necessarily. The
Third Law of Techonomics says there will be smaller companies, not fewer jobs. It
means there will be more opportunities for companies with a single-minded, specialized,
“value-add” purpose. These companies (if they are to evolve and thrive)
will provide their customers with exceptional goods and services, focusing on the
things they do best, the things that cannot easily be outsourced.
Several modern business practices have arisen due to the combination of “perfect
information” and transaction cost reduction. These include:
Outsourcing.
This is the common practice of buying products from an
external source rather than making them internally. As technology
advances to provide information on suppliers and the ability to remotely
monitor their production rates and quantities, outsourcing increases.
JIT (just in time) manufacturing/delivery.
JIT manufacturing networks
result from the coordination of production needs between different suppliers
to minimize work in progress and significantly reduce inventory
costs. Computer technology (Moore’s Law) combined with expanding
networks (Metcalf’s Law) makes JIT possible. And with the continuing
cost reductions in the related technologies, JIT now affords a strong
competitive advantage to those using it.
Mass customization.
Mass customization takes JIT to an extreme by
maintaining no inventory until the customer has placed a definitive order.
Using the Internet to take orders and JIT to then fulfill them, the production
pipeline holds no wasted inventory, and the producer can always use the
most advanced (or inexpensive) components to supply the customer. Computer
technology, combined with expanding networks and the ease of
using the Internet, makes mass customization a reality today.
Globalization.
Outsourcing was a local approach in the 1960s, a national
approach in the 1970s and 1980s, and has progressed to an international
approach in the 1990s and 2000s. The diminishing cost of worldwide
telecommunications brought on by the tremendous expansion of these
systems in the 1990s (the Internet telecom boom) has eliminated the cost
barrier for international communication. The oceans are crisscrossed with
fiber optic cables, and the skies (from 100 to 50,000 miles out!) are
covered with satellites. As a result, your PC service call can be less
expensively handled in India than in Indiana when the total cost of labor
and communications is considered (not to mention the increasing labor
cost of benefits). Globalization started with manufacturing and has now
progressed to service/telemarketing and software development due to the
increasing interconnectivity at lower costs (First and Second Laws). Technology
now allows the economics of worldwide personal commerce to
flourish. As a result, anticipate labor rates for transportable occupations
to level out worldwide in the generation ahead as competitive industries
empower the third world populace to embrace technology and participate
in the world economy. As Thomas Friedman correctly asserts, the world
is (becoming) flat.
Lean organization.
The lean organization results from minimizing a company’s
internal operations and layers of management, focusing on the core
value proposition of the business, and outsourcing all other activities.
Successful lean organizations understand the true nature of their “value
add,” the special quality of a good or service that makes them desired by
the consumer.
Today, we send an e-mail to Singapore, look at a Web site hosted in the U.K.,
buy a product made in China, and get technical help from a service representative
in India — all in the same day or even a few minutes.
Instantaneous, inexpensive, and ubiquitous worldwide communications are transforming the world economic order within a single generation.
The implications not only affect individual businesses,
but marketplaces, national economies, and entire global cultures.
Another way of looking at the Third Law of Techonomics for organizations is
in terms of productivity: output per employee. In simplest terms for a business, this
metric becomes revenues per employee. Whether the revenue generator is a product
or service, this metric is one that can be used to quickly determine current productivity
and annual trends in operating efficiency. As the value of this metric increases,
either the headcount is diminishing or revenues are increasing, or both. Improving
productivity is the trend predicted by the Third Law.
As this simple metric is applied to a spectrum of organizations, one should
observe a clustering of the values depending on the type of business, its capital
requirements, and its product offerings. For instance, a cleaning service with nonskilled
workers, little capital requirement, and a limited marketing overhead might
thrive with an annual revenue metric of $50,000/employee. On the contrary, a large
manufacturer with a significant cost of goods, high capital requirements, mass
marketing costs, and distribution costs might be failing with a revenue/employee
figure of $100,000. There are different ranges of this metric for different industries,
but the annual trends in revenue per employee should always be increasing if the
organization is thriving and adopting effective practices to increase productivity.
In view of the many opportunities for productivity gain, The Third Law of
Techonomics predicts that, if your organization is not continually getting more
efficient and productive, a competitor in your industry is likely to be overtaking it.
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