Accounting Outsourcing Economics

Transaction Cost Economics - Complete Controller

Transaction Cost Economics

Transaction cost economics is one of the leading linear models that explains what can be outsourced and what cannot. The model also tries to clarify why firms exist and set their boundaries. The main idea of free markets suggests that supply and demand drive the prices of goods and services, referred to as price mechanisms. According to one transaction cost theory, it is profitable to establish a firm because there is a cost associated with using the price mechanism. Another theory links transaction cost economics to economizing the expenses rather than strategizing.

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Accounting Outsourcing

When a firm decides to outsource all or some of its accounting functions to a professional, it aims to cut costs, attain competitiveness, or gain access to expertise. Outsourcing has long been a business trend, and the reasons to outsource vary from mundane cost reductions to simply following the trend. Many frameworks have been developed to determine what can be outsourced and cannot optimize costs. 

Production costs are associated with providing an internal activity for any firm. In contrast, if you purchase the same activity, it would be referred to as transaction cost. The transaction cost economics perspective suggests that all firms seek to equalize these costs before performing or outsourcing a function internally. Higher transaction costs would force a company to internalize its accounting functions.

Ex-Ante and Ex-Post Costs

Two basic transaction costs in outsourcing accounting for a firm include ex-ante costs related to negotiating and drafting charges incurred before entering an agreement. The ex-post costs are related to haggling, maladaptation, governance, and bonding costs. Maladaptation costs are associated with redefining the contract when it is still in motion but is not meaningful to one or both parties. Researchers believe that maladaptation may lead to opportunistic solid behavior by one party and is one of the main drawbacks of using a transaction cost framework. To understand how transaction costs work, we must first comprehend some key factors that can influence it.

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Asset Specificity in Transaction Cost Economics

The specific asset is a term usually used for assets with a more excellent value in their current use than if they had been used elsewhere. General assets, as opposed to these, have the same value everywhere. The four specific assets that have been identified include physically specific, human-specific, site-specific, and dedicated assets. Asset specificity is one of the most significant factors in determining outsourcing intensity from a transaction cost perspective. A high asset specificity signifies cost is only valuable within a specific transaction. 

In an accounting context, the physical assets of any firm would refer to the software and tools, while human assets would include information and human capital. Human assets will only be specified when an accountant requires knowledge about a specific characteristic of a firm to complete a defined accounting function. 

It suggests that a firm must search longer for professional accounting in times of high asset specificity, and contractual negotiations would be more belligerent. In such a scenario, it is beneficial for a firm to source rather than outsource, save high transaction costs, and allow for frequent adaptations. If a firm’s financial functions are highly tailored, the asset specificity would be directly influenced, and outsourcing would become more costly.

Environmental Uncertainty

Environmental uncertainty relates to the expected steadiness of the accounting workload due to volatile business activities. Vicissitudes in corporate structure, mergers, acquisitions, plant closures, and unstable sale and purchase invoices due to seasonality are some of the volatilities or uncertainties that directly impact the workload involving accounting practices. 

It contrasts the impact of high and low workload predictability on transaction costs. In an environment where a firm can accurately predict unforeseen circumstances, the transaction costs are low, and a firm should decide to outsource. However, an uncertain environment would escalate the transaction costs due to renegotiating the contract with a professional accounting firm, leading to insourcing. Moreover, a volatile environment forces a firm to reason that they are better placed to assess their needs; therefore, they should perform all accounting functions internally.

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Behavioral Uncertainty

Behavioral uncertainty in accounting refers to the difficulty of appraising the accountant for performing the job efficiently. When behavioral uncertainty increases, transaction costs increase because monitoring, writing, negotiating, and enforcing contracts will avert opportunistic behavior. Subsequently, the firm cannot evaluate the service provider’s performance, leading to high contract drafting costs. The transaction cost economics argue that this is a scenario where a company would decide to perform the accounting functions internally, and the manager would appraise the performances in-house.

Trust in Professional Accountants

Trust in professional accounting entails that the firm manager expects professional accountants to be trained professionals who are adept at their job, perform consistently, and are fair in all their dealings. Trust is an essential element that avoids opportunistic behavior by both parties. 

Transaction cost economics argue that the primary aim of both parties should be to minimize the degree of opportunism. Consequently, a higher degree of trust will reduce transaction costs and formal control mechanisms, leading to outsourcing accounting functions. Therefore, we can argue that trust is one of the crucial factors for a firm before hiring professional services.

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