From Coase to core

One of the world's most influential free-market economists for the last 70-plus years has been Ronald Coase, a lifetime of research and academia earning him the Nobel Prize for Economics in 1991.

In the last 78 years, he has earned worldwide recognition for his work in defining many of the economic laws and theorems by which we live today.

But he was not always a free-market thinker. The British-born American economist was a dyed-in-the-wool socialist when in 1931 he went on a research tour to the US to ascertain why industries were organised in different ways.

This research was conducted from a socialist point of view, but Coase, a deeply empirical thinker, was soon to change his thinking as he toured factory after factory. He came to understand that, left to its own devices, the free market would organise itself.

Among the deep insights after interviews with factory and company managers, his findings into economic analysis, transaction costs and why firms exist, he published in his seminal work: TheNature of the Firm, in 1937, which 54 years later earned him the Nobel Prize.

Coase came to understand that people and firms work together to reduce the cost of doing business. He noted that firms only arise when an entrepreneur begins to employ people, and these people only remain at the firm as long as there is a mutually beneficial value proposition. When the value attached to being with the firm exceeds the cost of being with it, then the employee will disengage, and seek employment elsewhere or become an entrepreneur himself.

The economic theory at the time was that the market was inherently inefficient, so it should always be cheaper to contract out then to develop one's own capacity. Coase found this was not necessarily true, as there were a variety of costs that are not directly associated with the manufacturing or service cost, such as search and information costs, bargaining costs, trade secrets and policing and enforcement costs. All of these can add to the cost of procuring something with a firm.

There are certain business activities which are core to survival and prosperity, while there are others that can be done better by other, more specialised companies.

Andrew Holden is MD of Bytes Outsource Services.

Coase concluded that firms will arise when they can arrange to produce what they need internally and avoid these costs.

This was a vital insight, and it provides the underpinning for why companies either outsource or choose to deliver a service or product internally. For as long as it is costlier to do your job yourself, you will consider outsourcing it; or if it is too costly, including opportunity cost, to outsource an activity, you will consider retaining it in-house.

This Coasian thinking has particular relevance when juxtaposed against the core-peripheral outsource model. This model posits that there are certain business activities which are core to survival and prosperity, while there are others that can be done better by other, more specialised companies.

As an example, most companies outsource their security, office cleaning and canteens, to mention just three important business activities. These activities are peripheral to their success, and can drive no revenue no matter how well they do them; accordingly, they can never be core. But some specialists, who have made their customers' peripheral activities core to their business, can make these activities very profitable.

It is incumbent on any company to examine with a keen and ruthless eye, which activities are not core and best outsourced, and which should be retained in-house. Some companies, such as Nike and 7-Eleven, have stripped down to their essentials, focusing only on the absolute competitive differentiators. Others find it hard to relinquish control and retain ownership of even mundane activities such as their print room and contact centre.

The core tend is to expand in good economic times and contract when times are tough, such as today. Because the core can be bloated with many unnecessary activities and functions being retained in-house, many companies are incurring unnecessary costs and could easily shave several percentage points of the operational costs by outsourcing non-core functions to an outsourcer who specialises in them.

In the next Industry Insight in this series, we will look at how to begin selecting the non-core processes, functions and activities so as to have the right outsourcer deliver them.

* Andrew Holden is MD of Bytes Outsource Services.