Transaction Cost Economics (TCE) Model



2.0 Introduction

The chapter contains the theoretical literature review, review of critical literature and identifying the gaps to be filled by the current research.

2.1 Review of Theoretical Literature

2.2.1 Transaction Cost Economics (TCE) Model

Transaction Cost Economics (TCE) Model
Criticism to the Transaction Cost Theory

The earliest work on transaction cost analysis is attributed to Coase (2007) who asked the question why some cost saving activities are organized through markets and other activities are organized within firms, given that both are alternative methods of coordinating activities in an economy.

Price mechanisms determine the allocation of resources and direct production. In firms, entrepreneurs and managers coordinate and direct resources and production, generally without the use of the price mechanisms (Masten, 2004). Building on the insights of Coase, Oliver Williamson is primarily responsible for the development of transaction cost economics. Acknowledging the work of earlier writers (Arrow 2009), Williamson combined elements of economics, law and organizational theory with the objective of developing a predictive law of economic organization.

In a series of books (1975, 1985, 1996) and articles Williamson distinguishes TCE from other theories of economic organisation16 by arguing that compared to standard economic theory, transaction cost economics is interdisciplinary, more micro-analytical, has different behavioral assumptions to neo-classical economics, regards the firm as a governance structure rather than a production function, and places importance on the effects of institutions17 on economic behavior. Besides Williamson other important contributions to transaction cost economics include Coase (2007), the early empirical work of, inter alia, Monterverde and Teece (2012), Stuckey (2013), Masten (2004), Crocker and Masten (2008) and Joskow (2005, 2007).

The basic unit of analysis is the economic transaction: a transfer of a good or service from one party to another rather than the unit of analysis used in neoclassical theory of a price and output of a good, service or resource. Williamson defines a transaction more precisely as occurring when ―a good or service is transferred across a technologically separable interface. One stage of activity terminates and another begins.

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2.2.2 Supply Chain Operations Reference (SCOR) Model

The SCOR model helps refine strategy, define structure (including human capital), manage processes and measure performance (Bomber & Ferlins, 2005). Organizations that have applied SCOR to help with supply chain problem solving, process improvement, process redesign, or business process engineering, have demonstrated that SCOR is an effective enabler for aligning an organization’s portfolio of improvement projects with strategic goals and objectives (Fayez, 2005).

Effective supply chain management is all about delivering the right product in the right quantity and in the right condition with the right documentation to the right place at the right time at the right price (Bennis &’Toole, 2005). Supply chain operating costs are under pressure from rising freight prices, global customers, technology upgrades, rising labor rates, expanding healthcare

Criticism to the Transaction Cost Theory
Criticism to the Transaction Cost Theory

costs, new regulatory demands, and rising commodity prices (Auramo, 2005). To control such costs there are thousands of potential metrics that supply chain organizations can and do measure. Managers need to zero in on the critical few that drive total supply chain costs within their organizations (Auramo, 2005).

Supply chains must periodically be assessed and redesigned in response to market changes, including new product launches, global sourcing, new acquisitions, credit availability, the need to protect intellectual property, and the ability to maintain asset and shipment security (Bennis &’Toole, 2005). Supply chain risks must be identified and quantified. Different organizations, even different departments within the same organization, can have different methods for measuring and communicating performance expectations and results (Fayez, 2005).

Supply chain leaders need a thorough understanding of the key competencies required for supply chain management roles, specific job qualifications, methods for developing future talent and leaders and the ability to efficiently source specific skills (Simchi & Kaminski, 2008).

2.2.3 Theory of supplier Constraints (TOC)

According to Davis, F. D. The more the constraints that a supplier faces to reach to the customers or to break in the market, the more the costs spread to the customers. (Perceived usefulness, perceived ease of use, and user acceptance of information technology, MIS Quarterly, 1989, pp.319-340), perceived ease of use and perceived usefulness are the two most important factors in explaining embrace of information technologies by individuals and organizations. He recognizes that, in addition, to perceived ease of use and perceived usefulness, subjective norms is also an important factor affecting adoption decisions of individuals. Many scholars have applied these models in explaining various types of business IT applications and e-commerce applications.

Criticism to the Transaction Cost Theory
Criticism to the Transaction Cost Theory

However, analysis of empirical research with TAM is not totally conclusive. (Venkatesh et al, User  acceptance  of  information technology: Toward a unified view” MIS Quarterly, 2003, pp.425-478) consolidated all the  prior  studies  on  acceptance and usage in information technology and produced a holistic  view  of  individual  acceptance  and  usage behavior pertaining to information systems.

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TAM’s have been developed in response to a need to evaluate users’ subjective satisfaction rates, and to use such rates as a predictor of a system’s success (Davis, 1989; Davis et al., 1989). Different theories and models conceptualize the acceptance in various ways, but a common characteristic is that all of them belong to the research tradition of social cognition, a field that tries to account for human action by applying psychological constructs such as attitudes, values and norms. For example, Fishbein and Ajzen (1975) theory of reasoned action (TRA) and theory of planned behavior (TPB) have been used extensively in various information technology attitude measurement scales (Dillon and Morris, 1996)

As noted by Goldstein (2000), procurement online companies try to provide a wide range of products and services to their customers in a more cost-efficient manner and try to automate the purchasing process through internet technology and informational connectivity. The basic types of web-enabled exchange models to automate procurement processes are increasing in number and include products, services, auctions, and inventory management. In picking a web-enabled exchange model, it is important to understand that the purchasing and supply management needs and environmental constraints of physician practices are different from those of home health agencies and hospitals. ‘Understanding the difference is vital to picking the right web-based procurement partners to automate your process and lower your costs’ (Goldstein, 2000)

In the past, the procurement function was seen as a way to execute a transaction between a buyer and a seller. Today, the procurement function needs to be executed on broader level. This means connecting different partners and helping them come up to the mark (Shah, 2002).

However, major online platforms in the area of procurement have been developed to date. Integrity, transparency and cost saving are just a few of the profits derived from these platforms. Some of the most successful online procurement platforms are explained in the table below with their definitions.

2.2.4  Effects on length of the sourcing process

Delays in the public procurement process are any constraint that prevents procurement events from taking place in accordance with the procurement plan and schedule (Lynch, 2011). Some common causes of delays in the procurement process are:

  1. Failure to properly plan all procurement events and to use the appropriate procurement method.
  2. Requesting entity fails to submit procurement requests on time consistent with the procurement plan and schedule.
  • Technical specifications, scope of work or terms of reference prepared later than scheduled.
  1. Procuring Entity receives incomplete technical specifications, scope of work or terms of reference.


Lynch, in the book Public Procurement and Contract Administration, states that avoiding delays in the procurement process not only saves time and money, it also permits the timely award of contracts.  He also states that, the only way to avoid a delay is a timely update of information on suppliers, organization’s needs and any supplier alternatives in case of a relationship breakdown. He adds that a real time platform is especially important in project procurement management because it could delay the completion of the project.

All stakeholders: the procuring entity, evaluation panel members, approving authority, requesting entity, etc., involved in the bidding, evaluation and selection phase are responsible for making every effort to avoid delays in the procurement process. No single department can do this. It has to be a collaborative effort allowing real time information processing (Lynch, 2011).

According to Lynch, 2011, a real time supplier and organizations’ information would provide the following advantages:

  1. A realistic determination is made of the availability of a market to satisfy or a perfect supplier.
  2. The appropriate procurement method is assigned according to the strengths and weaknesses of a supplier because this is important for estimating the procurement lead-time.
  • The best inventory levels are held since replenishments are accurately requested and made in real time.
  1. Reduced costs of communication between suppliers and the buying organization.

2.2.5 Effects on Supplier Base

A supplier base can be defined as the number of available prospective suppliers (Matthews, 2011). A limited supplier base is not necessarily a small supplier base. As we enter into the second decade of the 21st century, we may fully be in the age of the supply chain.  Supply chain management expands the reach of the firm beyond its immediate grasp to those places where competitive advantage is derived—in particular, the supplier base. Essentially, it is no longer firm competing against firm—Boeing against Airbus, Target against Wal-Mart; rather, it is supply chain vs. supply chain.

As we shift the competitive focus from the firm to the supply chain, we must recognize that, like physical chains, no supply chain is stronger than its weakest link.  However, when the weakest link resides beyond the boundary of the supply chain organizer (firm), significant problems can and do occur. This is particularly true with regard to the supplier base. In fact, one recent study found that 28 percent of the firms surveyed identified supplier failure and continuity of supply as their primary supply chain risk factor.

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This raises an interesting issue: How does a firm ensure that it has the “right” set of suppliers in its supply chain?  Addressing this cannot be left to chance. It is far too important—as any company that has suffered a supplier-related disruption can attest. The supplier base must be carefully and continuously managed. The supplier base must be managed strategically, not tactically; it must be managed with the perspective that the supplier base, like the business environment in which it operates, is dynamic and ever changing.  That is, existing suppliers often leave (as a result of bankruptcy, acquisition, or changes in the buying company’s strategic direction) and new, attractive suppliers enter.  Finally, the firm should recognize that managing a supplier base does not always mean supplier reductions.  There may be strategic reasons why the base may need to be larger, rather than smaller.

A new approach is emerging called supplier base management (SBM) that effectively deals with these challenges. Supplier base management is a systematic, holistic, strategic approach to planning, developing, and managing the supplier base. However, SBM continues to lack its major cause of development: sustainability. As it has proven, there still exists the gap of real time information. As indicated by Lynch, 2011, the only way SBM will overcome the physical or distance barrier is only through online hosting..

2.2.6 Effects on the Cost of Sourcing.

The global marketplace is changing fundamentally. Suppliers around the world are now stretching their markets to sell and compete on a global scale. Many advanced exiting suppliers have developed and are providing massive cost savings through new supply chains developed and sustained online. Knowing where these new and existing suppliers are, and how best to source from them, is key. Sourcing refers to the holistic process of obtaining or procuring materials while e-Sourcing refers to the sourcing process enabled with the appropriate web-enabled, collaborative technology to facilitate the full life-cycle of the procurement process for both buyers and suppliers (Lynch, 2011).  In a more restricted way, e-Sourcing is sometimes limited as the process of interaction with internal and external stakeholders from the identification of a requirement to the negotiation of a contract. Lynch explains that e-Sourcing is an extension to the tools formerly available in e-Procurement. It is also the area where the greatest savings can be made.

An online supplier platform will assist in real time accessibility of suppliers’ information, how they can be contacted and any relevant information necessary to the sourcing process. The online supplier platform will in simple operate as a marketing forum where suppliers are available for contact that will lead to sourcing. An online supplier platform will affect the process of sourcing directly and indirectly in the following ways:

Reduced direct costs; Direct costs of preparing and issuing the ITT and responding with tenders will be greatly reduced. These costs include distribution costs, paper, couriers etc. Collaborative working reduces the need for teams to travel for face to face meetings

Improved Contract Prices: Buying organizations are able to focus on primary or core activities rather than administration of contracts and searching of suppliers. The online supplier platform avails the ability to identify and act on collaborative opportunities.

Reduced risk of failure. An online supplier platform will reduce the risk of awarding contracts to inappropriate suppliers leading to improved performance and reduced whole life costs.

Process efficiencies: Efficiency gains by reducing the time taken in the tendering process, releasing valuable resource earlier. Applies to both the buyer and the supplier and encourages all parties to follow the best practice, enabling a more consistent approach to tendering across the private and public sectors.

2.2.7 Effects on supplier information

As Leonard Bernstein wrote, “To achieve great things, two things are needed: a plan and enough time.”  But what about information? Most start ups, especially these days, face significant information challenges.  While it is true that the cost of advertising has come down significantly in the past ten years, the costs of paid search, banner ads and print advertising can still be unattainable for many small suppliers. As the desire by suppliers to advertise on online social platforms such as facebook and twitter, which beats physical boundaries, intensifies, the cost of doing so is rather discouraging (Lovren, 2013) For example, Launching a new Twitter account, complete with setup and outsourcing content creation/consumer interaction (all 140 characters at a time), costs an average of $2,000-$4,000 per month – and that’s just for Twitter. With that said, the total price range was $1,000-$7,500 per month.  Besides, to set up a new Facebook account and provide limited ongoing training to business partners, online PR agencies charge an average of $2,500-$5,000 per month, with some going as high as $9,000. Of course, this also includes status updates and interacting with customers. If you’re shelling out a minimum of $4,500 per month for Facebook and Twitter management, you’re not getting any strategy behind the efforts. As these supplier advertisement cost increases, the costs are passed over to the buying organizations leading to high costs per unit.

An online supplier platform will not only provide easy accessibility but also a cheap and efficient marketing platform for the suppliers. These reduced costs will lead to low operational costs by the suppliers leading to low cost per unit.

2.3 Review of critical literature

2.3.1 Criticism to the Transaction Cost Theory

There are 3 major criticisms to the theory: It focuses on cost minimization, it understates the cost of organizing and that it neglects the role of social relationship in economic transactions

There are a set of theories classified under – Resource based theories, which emphasize that organizations would have to make and exploit transaction specific investment under conditions of

Criticism to the Transaction Cost Theory
Criticism to the Transaction Cost Theory

uncertainty to gain long term competitive advantage. Minimization of transaction cost would have little advantage if transaction specific assets aren’t valued in the market. Hence, it is important to move beyond the perspective that “economy is the best strategy” for an organization.

When we attempt to do a certain transaction in house, there is no guarantee that this would reduce the negotiations and haggling associated with the transaction. In reality, there is a higher possibility of costly bargaining and influential behavior. Even the authority to resolve such issued could behave opportunistically. Given this situation, TCT underestimates the costs associated with the organizing the transaction within the firm.

In real life, many transactions are influenced by the expectations that are formed by the history of the relationship between the parties. This indicated that transactions are embedded in the networks of social relationship. It is these relationships that explain the situations like trade between close friends without the presence of any contracts, commitments etc. The TCT neglects the role of social relationships in transactions.

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2.3.2 Criticism of supply chain operations reference model

Overall, the SCOR-model facilitates decision making and resource allocation. It also embeds the concept of continuous improvement in the user organization, which can fuel a competitive advantage if the user perseveres despite the complexity of the model.

The SCOR-model provides a cross-industry standard application and has been readily adopted by the information technology and consulting communities. It’s also well suited for electronics and consumer goods. However, the model’s framework of plan, source, make, deliver, and return focuses on improving the efficiency of internal processes. Because of that, it seems to be limited to transaction based or internally focused environments and is not supportive of organizations that are extending their view to include strategic partnerships and extended supply chain efficiency.

2.3.3 Criticism of The Theory of Constraints

Criticisms that have been leveled against TOC include:

Claimed sub optimality of drum-buffer-rope. While TOC has been compared favorably to linear programming techniques, Trietsch from University of Auckland argues that DBR methodology is inferior to competing methodologies.  Linhares, from the Getulio Vargas Foundation, has shown that the TOC approach to establishing an optimal product mix is unlikely to yield optimum results, as it would imply that P=NP.

            Unacknowledged debt. Duncan (as cited by Steyn) says that TOC borrows heavily from systems dynamics developed by Forrester in the 1950s and from statistical process control which dates back to World War II. And Noreen Smith and Mackey, in their independent report on TOC, point out that several key concepts in TOC “have been topics in management accounting textbooks for decades.”

People claim Goldratt’s books fail to acknowledge that TOC borrows from more than 40 years of previous management science research and practice, particularly from program evaluation and review technique/critical path method (PERT/CPM) and the just in time strategy. A rebuttal to these criticisms is offered in Goldratt’s “What is the Theory of Constraints and How Should it be Implemented?”, and in his audio program, “Beyond The Goal”. In these, Goldratt discusses the history of disciplinary sciences, compares the strengths and weaknesses of the various disciplines, and acknowledges the sources of information and inspiration for the thinking processes and critical chain methodologies. Articles published in the now-defunct Journal of Theory of Constraints referenced foundational materials. Goldratt published an article and gave talks with the title “Standing on the Shoulders of Giants” in which he gives credit for many of the core ideas of Theory of Constraints. Goldratt has sought many times to show the correlation between various improvement methods. However, many Goldratt adherents often denigrate other methodologies as inferior to TOC

2.4 Summary and gaps to be filled

Logistics plays key role in supporting organizations as they strive for more efficient management systems as in the business practices, the inefficient logistics system together with the inefficient internal management would disable the organization to respond to the needs of patients with the lowest cost at the shortest feasible time frame, helping to achieve the organization’s targets or vision.

            It is therefore necessary for KNH to establish a system that integrates suppliers in the East African region and beyond in order to increase flexibility amongst its operations.  In view of this, the organization will benefit from automated control that will ensure easy access to information and real time update of the supplier.

Secondly, a sustainable supplier platform’s ability to provide a real time update of supplier information is vital in filling the ever increasing lack of credible supplier data. This is because the platform will provide an online forum where suppliers upload their information and their terms of trade where buying organizations can access the information on real time, from different parts of the world. As organizations aim for international markets, only a sustainable supplier platform will provide an equal and healthy competition. This is because the platform will act as a marketing tool to both big and small companies and hence a healthy competitive ground.

On the side of the buying organization, the larger the supplier base, the more the probability of selecting the best supplier. Besides, there will be efficiency in selecting suppliers and hence reducing delays that are frequently experienced. The platform will reduce costs to both the supplier and buying organization as both direct costs such as travelling and communication, manual preparation of TTI and indirect costs such as production stoppages due to lack of timely replenishment will be avoided.

2.5 Conceptual Framework.


Transaction Cost Economics (TCE) Model
Conceptual Framework

It is the desire for every organization to achieve strategic sourcing. This is the systematic, long term and holistic approach to acquiring current and future needs of an organization at the lowest total cost of ownership (TCO) and lowest risk to the supply line.  This process creates a closed loop link between customer and the supplier to ensure continuous improvement in quality, delivery, cost and service while providing the means to achieve optimal efficiencies in both (customer & supplier) organizations. A sustainable supplier platform promises a real time update of information between the supplier and the buying organization leading to short replenishment periods and hence strategic sourcing.

Interdependent Variables                                                                          Dependent Variable

Figure 2.1 Conceptual framework

2.5.1 INTERPRETATION OF THE CONCEPTUAL FRAMEWORK Length of the sourcing process Supplier Base

The term supplier base refers to the total number of prospective suppliers (Monczka, 2011). Although companies prefer having a small supplier base which can be easily managed, it is important to note that an effective supplier base is one with rampant competition on prices, quality and variety. An online supplier platform will provide a sufficient supplier base for buying organizations to discover new or exciting probabilities. Cost of sourcing

It is the aim of any organization whether public or private to reduce cost. This is because cost reduction translates to an increase in profit hence continuity of the firm. Varieties of benefits of B2B e- procurement have been reported as achieved or expected in the academic literature.  Among  different  benefits  the  most  common  ones  are  transactional costs and buying price reduction, process shortening improvement of information exchange and control. Such benefits are grouped into taxonomies that include operational and strategic (Croom 2006).  E-procurement  has  a  far  greater  potential  for  cost  savings  and  business improvements  than  online  retailing  or  enterprise  resource  planning  systems,  and  will permanently and fundamentally reform the way we do business in the future (Neef 2010)

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It is a continuous measurement of the effectiveness of the key performance measures that is vital to the successful management and delivery of benefits realization. Thus cost measurement especially in difficult trading conditions is likely to be prerequisite for project approval and the only way to demonstrate success and identify problems early enough to manage them effectively. In order to calculate recurring benefits key savings drivers for e-procurement include transactional payment management information and price benefits.

These drivers are interdependent each enabling the other’s delivery. The interaction between them is important implying that the achievement of tangible benefits in the firm of price improvement is reinforced at each successive negotiation by improving interaction of the drivers.

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Sourcing refers to the holistic process of obtaining or procuring materials while e-Sourcing refers to the sourcing process enabled with the appropriate web-enabled, collaborative technology to facilitate the full life-cycle of the procurement process for both buyers and suppliers (Lynch, 2011).

A sustainable supplier platform will assist the procurement function need for information in the following: Centralized cloud based source of supplier information, real time access to up to date supplier information, gateway for all your suppliers and streamlined and audited processes

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