Attention - Decreasing Transaction Costs!

Do you want to buy a property or are you thinking about it? Maybe you have even just bought a property? You poor thing!

Real estate purchases are a tiresome topic from the buyer's point of view. This is also and especially true in times of low interest rates. Neighbors, investment advisors and friends urge a decision: "If you wait another two years, everything will be another 20% more expensive." Potential home builders are faced with serious questions: What living space is needed? Do I need a garden, and if so, what size? How old can the property be? What location? And of course: What can it cost?

Transaction costs - an often underestimated calculation item

In their considerations, many buyers easily forget that in addition to the purchase costs of the property, there are numerous costs surrounding the transaction itself that should be included in their calculations.

Think, for example, about the costs of finding and informing a buyer: How much time, energy and money do you invest in selecting a suitable property? (This also includes, quite banally, the tank of gas you use to drive to the show house exhibition). This also applies to the opportunity costs of time that you could have filled with possibly more meaningful things than discussing real estate with your partner. Inspection costs also come into play: how often do you travel to the construction site to monitor that construction is proceeding properly? And how much time and nerves do the phone calls with the architects and craftsmen cost? Even when the purchase is officially completed and the property has been handed over, costs continue to be incurred - the so-called adaptation costs. The conversion of your veranda into a conservatory, for example, is a post-contractual construction measure that you carry out in order to use the property in your interest.

Transaction cost theory according to Ronald Coase

The fact that all these additional costs have to be taken into account when carrying out any transaction on the market was recognized by the British economist Ronald Coase as early as the 1930s. He was disturbed by the idea in classical economics that a purchase is made "free of charge". Transaction cost theory was born.  (He even later received the Nobel Prize for his essay "The Nature of the Firm.")

Why do companies exist at all?

With his theory, Ronald Coase was able to answer an old question that no one before him had dared to ask: Why do companies exist at all? Why, for example, is a contract of employment concluded with an employee when the individual action can be purchased?

The answer to these questions can be found in the transaction cost theory: The costs that arise in addition to the purchase price (transaction costs) are so high that it is worthwhile for entrepreneurs to create hierarchies in order to control work processes internally and to take over the tasks themselves.

In their considerations, many buyers easily forget that, in addition to the purchase costs of the property, there are numerous costs associated with the transaction itself that should be included in their calculations.

Think, for example, of the costs of acquisition and information: How much time, energy and money do you invest in selecting a suitable property? (This also includes, quite banally, the tank of gas you use to drive to the show house exhibition). This also applies to the opportunity costs of time that you could have filled with possibly more meaningful things than discussing real estate with your partner. Inspection costs also come into play: how often do you travel to the construction site to monitor that construction is proceeding properly? And how much time and nerves do the phone calls with the architects and craftsmen cost? Even when the purchase is officially completed and the property has been handed over, costs continue to be incurred - the so-called adaptation costs. The conversion of your veranda into a conservatory, for example, is a post-contractual construction measure that you carry out in order to use the property in your interest.

Transaction cost theory according to Ronald Coase

The fact that all these additional costs have to be taken into account when carrying out any transaction on the market was recognized by the British economist Ronald Coase as early as the 1930s. He was disturbed by the idea of classical economics that a purchase is carried out "free of charge". Transaction cost theory was born.  (He even later won the Nobel Prize for his essay "The Nature of the Firm.")

Why do firms exist at all?

With his theory, Ronald Coase was able to answer an old question that no one before him had dared to ask: Why do companies exist at all? Why, for example, is a contract of employment concluded with an employee, when the individual handle can be purchased?

The answer to these questions can be found in the transaction cost theory: The costs that arise in addition to the purchase price (transaction costs) are so high that it is worthwhile for entrepreneurs to create hierarchies in order to control work processes internally and to take over the tasks themselves.

This can be illustrated with a simple example: What effort would companies have to make to buy their balance sheet on the open market every year? An external accountant incurs high costs and must be constantly monitored. Once the project has been completed and the balance sheet drawn up, all his accumulated knowledge is lost again and has to be rebuilt the following year.

Transaction costs are the glue for traditional value chains: In the manufacturing economy of the 20th century, it was not worthwhile to incur the high transaction costs of creating goods and services externally. The monitoring and control costs were simply too high for assembly line activities, for example.

Companies simply save money if they do not have to buy every service on the market but can integrate it into the company's workflow.

Make or Buy:?

As a consequence, transaction cost theory provides the basic framework for difficult management decisions: The make-or-buy decisions. Should work processes such as customer consulting or parts of IT be "outsourced" or remain within the company?

When making such decisions, the transaction costs must be included in the calculation. The following applies: Outsourcing is worthwhile if the purchase price + the expected transaction costs are below the internal production costs. In a first wave in the 1970s and 1980s, this consideration led to the outsourcing of parts of production to Southeast Asia - and to the rise of the so-called Tiger States.

How digitization will change the value creation processes of the future

The economy is currently facing a new wave of outsourcing. Digitalization is having a massive impact on the upcoming make-or-buy decisions. New technical possibilities such as the cloud are leading to falling transaction costs - across all transaction cost types.

This, too, will be illustrated by a practical example. Just think briefly about how the public cloud provider AWS has changed the purchasing process for IT services in recent years:

• Start-up costs: IT services such as compute, network and storage are described and can be easily researched (example for compute).
• Agreement costs: Creating a new account is child's play (see here).
• Settlement costs: All processes for cost management, invoicing and account administration are automated or can be self-administered via a simple user interface (see here).
• Control costs: To simplify control tasks, Amazon provides services such as AWS Cost Explorer and cost/benefit reports (see here).
• Adaptation costs: One of the most relevant functions of the cloud is the so-called Autoscale (here). This allows resource consumption to be automatically adjusted to actual demand.

How did this compare to switching a data center provider 15 years ago?

Transaction costs without end: demand analyses, demand development scenarios, tenders, tender consultants, tender rounds, final offers, contract negotiations, transitions and change projects, escalations, misplanning, misunderstandings and much more.

The make-or-buy decision must be rethought

But our corporations, with their huge IT purchasing departments and sourcing experts for IT services, are tailor-made for these tasks: new tenders are issued every five years, escalated in the meantime, pressure is applied, and unsuccessful major projects are managed.

At the same time, two developers release an iOS app for sharing photos and videos in 2010. They find 30 million users within two years and sell their Instagram to Facebook for a billion dollars in 2012.

The comparison shows: The make-or-buy decision must be rethought. Processes that are not part of the core business can increasingly be outsourced. In the future, all processes that can be digitized and/or automated will be put to the test.

Digital transformation without agile business management, cloud and modern software development without a chance

Companies now have the opportunity to restructure their internal processes when developing new products and services. The magic words for this development are agile business management, cloud and modernization of software development processes.

Product A can be created with supplier B and the software offering from the Azure cloud - delivered and billed quasi transaction cost-free via API. Product B, on the other hand, accesses logistics company C and is thus independent of the logistics provider with which the company previously worked.

More and more new "Minimum Viable Products" can be programmed, integrated and deployed this way. If the customer does not accept the new functionality, then at least the manager has not invested a lot of resources (Fail Fast Learn Fast) and he tries something new.

New rules of the game for the economy - traditional value chains dissolve

Digitization is thus changing the rules of the game in business. While for a long time it made sense from a business perspective to internalize a large part of business processes, companies now have to find their place in the network economy. To do so, they face the following three major challenges in particular:

• Bringing IT to the cloud: Outsourcing your own IT to the cloud as well as replacing traditional IT outsourcing with cloud IT.
• Modernize software development: Only modern software development approaches can truly leverage the benefits of the cloud.
• Make decisions agile: Only with agile testing of new services on the market will digital business models become successful.