2 September 2010 | Richard Wilding

The application of transaction cost economics to supply chain management can transform business relationships and boost performance levels, as Richard Wilding explains

In October 2009, Oliver Williamson received the Nobel Prize for his analysis of economic governance. Williamson, professor emeritus of business, economics and law at the University of California, Berkeley, has devoted his life to the study of “transaction cost economics”.

This work has significant implications for supply chain management, but few professionals know of the work and its sweeping implications, if adapted.

Williamson’s views about how to contract with suppliers responds to the industry-wide need for companies to work more smartly with their vendors. Companies have been focusing on “lowest price” versus “best value”, which creates hidden transaction costs. Williamson’s work, sometimes controversially, shows this approach is short‑sighted and inefficient. Instead companies should be creating business relationships where both parties have a vested interest in each other’s success. It is the only way both company and supplier can create a positive and truly collaborative working relationship.

Case research has validated Williamson’s lessons, showing companies can work with their suppliers to drive transformational improvements in cost structures and performance levels. In a recent white paper we have identified 10 lessons for supply chain management; a few of the more controversial lessons are outlined below. Does your business work in this way? Would you be prepared to change?

Build trust by leaving money on the table. This may sound foolish, but it can signal a constructive intent to work co‑operatively. As the old proverb says: “Give and it will come back to you, generosity gives rise to generosity.”

Your style of contracting matters, so be credible. Organisations that use their “muscle” to gain an advantage over suppliers may have a short-term victory, but they will lose in the long term. Companies will ultimately face higher costs from switching suppliers or from suppliers being forced to use conventional negotiations to put in short‑term and costly contractual provisions and behaviours that simply drive up hidden costs.

Use a contract as a framework, not a legal weapon. Creating a detailed contract and associated statement of work puts the outsource provider and customer into a “box”, which limits innovation. Instead of trying to “guess” about the future, it is better to indicate an outline of the work to be done and provide recourse for ultimate appeal and focus on the process and tools to be used, not on the work to be done.

“Shared vision” can minimise transaction costs. Whenever possible, create a shared vision – predicted alignment – to guide how company and supplier will work. Develop pricing models that reward and incentivise suppliers for achieving the desired outcomes.

The whitepaper is free to download at www.vestedoutsourcing.com

Key points

• Ensure your style of contracting is credible

• Use a contract as a framework, not a legal weapon

• Create a shared vision to guide how company and supplier will work, minimising transaction costs

Richard Wilding is chair in supply chain risk management, Centre for Logistics and Supply Chain Management, Cranfield School of Management