Transaction Cost Economics
Transaction cost economics is one of the leading linear models that explains what can be outsourced and what can’t. The model tries to clarify why firms exist and set their boundaries. The main idea of free markets suggests that the supply and demand drives the prices of goods and services which is referred to as price mechanism. 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 costs rather than strategizing.
When a firm decides to outsource either all or some of its accounting functions to a professional, the aim is to either cut costs, attain competitiveness or gain access to expertise. Outsourcing has captured the thoughts of businesses for a long time now and the reasons to outsource vary from mundane cost reductions to simply following the trend. There are many frameworks which have been developed to figure out what can be outsourced and what cannot, in order to optimize costs.
For any firm, there are costs associated with providing an activity internally which are called production costs while, if you purchase the same activity, it would be referred to as transaction cost. The transaction cost economic perspective suggests that all firms seek to equalize both these costs before performing a function internally or deciding to outsource it. Higher transaction costs would force a company to internalize their accounting functions.
Ex-ante and Ex-post costs
There are two basic transaction costs in outsourcing accounting for a firm, including ex-ante costs which are related to negotiating and drafting charges that are incurred before entering an agreement. The ex-post costs are related to haggling, maladaptation, governance and bonding costs. Maladaptation costs are related to 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 strong opportunistic behavior by one party and is one of the main drawbacks of using a transaction cost framework. To understand how transaction costs actually work, we first need to comprehend some of the key factors that can influence it.
Asset Specificity in Transaction Cost Economics
Specific asset is a term usually used for assets that have a greater value in their current use rather 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 the intensity of outsourcing in transaction cost perspective. A high asset specificity signifies cost is only valuable within a specific transaction.
In 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 particular knowledge about a specific characteristic of a firm to complete a defined accounting function. Transaction cost economics suggest that in time of high asset specificity, a firm would have to search longer for professional accounting and contractual negotiations would be more belligerent. In such a scenario, it is beneficial for a firm to in source rather than outsource and save high transaction costs and allow for frequent adaptations. In case the financial functions of a firm are highly tailored, the asset specificity would be influenced directly and outsourcing would become more costly.
Environmental uncertainty relates to the expectedness and steadiness of accounting workload as a consequence of 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 have a direct impact on the workload involving accounting practices.
Transaction cost economics juxtaposes the effect of high and low predictability of workload on transaction costs. In an environment where a firm can accurately predict the 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 renegotiation of 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 own needs, therefore, should perform all accounting functions internally.
Behavioral uncertainty in accounting refers to the difficulty of appraising the accountant in terms of performing the job efficiently. When behavioral uncertainty is high, the transaction costs will be higher because of monitoring, writing, negotiating and enforcing contracts in order to avert opportunistic behavior. Subsequently, the firm is unable to evaluate the performance of the service provider which will lead to high drafting costs for contracts. The transaction cost economics argue that this is such 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 manager of a firm expects professional accountants to be trained professionals who are adept at their job, perform consistently and are fair in all of their dealings. Trust is an essential element of the deal and avoids any chances of 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 the transaction costs and formal control mechanisms leading to outsourcing of accounting functions. Therefore, we can argue that trust is one of the crucial factors for a firm before deciding to hire professional services.
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