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 supply and demand drive goods and services as a 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. However, 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, it aims 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.
Many frameworks have been developed to figure out what can be outsourced and what cannot optimize costs. For example, there are costs associated with providing an activity internally, which are called production costs 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 both these costs before performing a function internally or outsourcing it. Thus, for example, higher transaction costs would force a company to internalize its accounting functions.
Ex-ante and Ex-post costs
There are two basic transaction costs in outsourcing accounting for a firm, including 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 related to redefining the contract when it is still in motion but is not meaningful to both parties. Researchers believe that one party’s maladaptation may lead to strong opportunistic behavior and is one of the main drawbacks of using a transaction cost framework. To understand how transaction costs work, we first need to comprehend some of the key factors influencing it.
Asset Specificity in Transaction Cost Economics
The specific asset is usually used for assets that have a greater 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 determining the intensity of outsourcing from a transaction cost perspective. A high asset specificity signifies cost is only valuable within a specific transaction. For example, 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 particular knowledge about a specific characteristic of a firm to complete a defined accounting function. Transaction cost economics suggests that a firm would have to search longer for professional accounting in times of high asset specificity, and contractual negotiations would be more belligerent.
It is beneficial for a firm to source rather than outsource and save high transaction costs and allow for frequent adaptations in such a scenario. However, if 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. For example, 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 accounting practices’ workload.
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 unforeseen circumstances, the transaction costs are low, and a firm should 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 and perform all accounting functions internally.
Behavioral uncertainty in accounting refers to the difficulty of appraising the accountant to perform the job efficiently. When behavioral uncertainty is high, the transaction costs will be higher because of monitoring, writing, negotiating, and enforcing contracts to avert opportunistic behavior.
Subsequently, the firm is unable to evaluate the service provider’s performance, which will lead to high drafting costs for contracts. The transaction cost economics argues that this is such a scenario where a company would internally decide to perform the accounting functions. 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 argues 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 accounting functions. Therefore, we can argue that trust is a crucial factor for a firm before deciding to hire professional services.About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks™️ file, critical financial documents, and back-office tools in an efficient and secure environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.