Transaction Cost Economics

Transaction cost economics is a strategically articulated combination of law, economics, and organizational theory of a firm.  TCE provides a framework designed to increase the efficiency of transaction costs incurred by an entrepreneur or a firm by using economic theory in making key decisions regarding resource allocation. Transactions can be very complex, thus it is very important that both parties in any transaction agree on terms that establish a partnership in effort to promote a culture where both agents work to ensure mutual success. Without laying this foundation attempts to form outsourcing relationships could potentially become consumed by terms and conditions.  Proactive firms outsource for a common reason, that their in house operations are too expensive, ineffective, or both. For example it may be cheaper to produce in house, but wasteful of employees time, or may be cheaper to outsource because the firm does not have the adequate knowledge or technology to produce the output.  TCE is concerned with the governance of a firm’s efficiency; making efficient decisions concerning the coordination of resources either in house or in the market creates an opportunity to produce cost savings, and charge a premium price. In the coordination of resources a firm must identify core competencies central to their competitive advantage, which should remain in house. Any function of a firm that is a special purpose asset needed to operate efficiently should remain in house, specifically because if a change is needed and there is an existing demand (product order) the power has shifted to the outsourced provider.  TCE observes a firm as a government structure that has the ability to reduce uncertainty by controlling situations within and outside the firm, the amount of information needed to explore every angle of an opportunity is too great due to the existing mutual knowledge of the market. This can be overcome by introducing a well-articulated contract thus reducing uncertainty creating a competitive advantage.  The more uncertainty that exists the more difficult it is to use a contract when employing the market.  Very complex contracts enhance the prospect of self-interest (the more complex a contract is the more incomplete it is) which can be described as the hazard of opportunism, where one party may make an investment in support of the contract which the other party does not want to pay. TCE resembles game theory, it is a strategic process where the winner gets paid and the looser gets played.

After Dragone had stepped down as CEO, Keurig outsourced the search for a new CEO through Onsstott group which is an executive search firm that specializes in this area and has a large network of people. In light of TCE this was a good decisions Onstott group would have a much wider range of proximity in attracting potential personnel to fill in as the new president of the company. This gave a greater opportunity to keurig to find a candidate that best fit the company’s target outcome.  By outsourcing this function keurig created an efficient transaction, the terms of contract could be clearly stated, and could rely on the market to reduce uncertainty. The Onstott group presented them with many qualified candidates; it was up to Keurig to decide who they would hire.

The decision was made to outsource marketing of the K-Cup by licensing the firm’s technologies on non-exclusive basis to coffee roasters who would market K-Cups under their own brand.  Creating alliances with established channels of distribution and marketing experience was a good decision. By doing this they have created a performance partnership, which in this case would benefit both parties involved. Establishing this relationship aligned the interest of both firms, creating a win-win situation, allowing the established brands to generate revenue through the innovative product, as well as create awareness for keurig. A contract in this case would be very easily stipulated, and uncertainty would be reduced.

Keurigs decision to conduct market analysis on existing customers within the firm was a good decision, Stevens ( V.P sales and Marketing) used existing brewers and k-cups to  gain information on end users reactions to the product, grouping its potential customer base into 3 main categories. To be specific and according to TCE market analysis can be an outsourced function, but because Keurig had already ordered existing brewers and k-cups, and Stevens had been brought on to service the massive roll out which was not even close to happening, he used his time efficiently to assess market demand, and create an effective sales pitch by placing brewers in office environments, asking questions and assessing end users reactions.  By doing this he reduced uncertainty, as well as gained valuable insight as to how distributors would sell both products to the OCS segment.

Keurig made a decision which promoted great opportunity to outsource sales offered by distributors of the OCS market segment, the sales pitch and presentation was developed in house but Keurig used the efficiency of the distributors to sell their product.  The sales process was developed to appeal to not just the office manager, but also the employees who would be utilizing the system. The sales pitch was asset specific, and a core competency which is why it was produced by Keurig, an effective sales presentation was directly related to market research on the OCS segment that was also conducted by an in house employee.  Keurig would be working very closely with how distributors would be positioning the Keurig system.

Keurig made a very pivotal mistake by investing in a special purpose asset by outsourcing the development of the k-cup packaging line. This was asset specific to the function of the company, and was a core competency central to the firm’s competitive advantage.  The only way that Keurig could have reduced uncertainty is by producing the development of k-cup packaging lines in house. Throughout the production of the packaging line change was needed on certain occasions, and Moore (outsourced supplier MTS) informed Lazars (Keurig) that he would not ship the first completed packaging line until he received an additional 180,000$ on top of the fixed cost already negotiated. Because stipulations of the contract were far too complex, uncertainty was increased and self-interest of the supplier created a bilateral monopoly putting Keurig in a very bad situation. Moore produced a product line that he knew could not be replicated fast, or efficiently even if reversed engineered by Keurig, he knew it could take months putting him in a position of power, especially knowing that a demand existed. Keurig was forced to make a payment to MTS in exchange.  Keurig had allowed MTS to position themselves as the only company capable of delivering the machines in the time frame required to meet the demand.  Short term contracts break down when asset specifity changes and power is shifted creating a hazard of opportunism where the supplier felt he made an investment in support of the contract which was far too complex to be certain demand existed. Keurig was forced to make a payment to MTS in exchange.  Keurig had allowed MTS to position themselves as the only company capable of delivering the machines in the time frame required to meet the demand.  Short term contracts break down when asset specifity changes and power is shifted creating a hazard of opportunism where the supplier felt he made an investment in support of the contract which was far too complex to be certain.

Keurig’s decision to outsource the development of its brewers was a mistake as these brewers were core competencies and central to the company’s future. The roll out schedule for brewing units and packaging lines were intertwined and equally important. Keurig also needed to maintain its timetable in order to continually develop its network of distributors and premium roasters, without precision timing of both the brewers and k-cups there distributors would be left empty handed.  Keurig was very concerned with the consistency and quality of the brewers that Vandelay industries was rolling out, they were being passed through quality checks with loose screws and parts falling out. Keurig should have realized that the brewers were also asset specific, and should have been an in house function.  The short term contract had broken down once again due to the fact that Vandelay industries had submitted its contract for the next order needed by fall and its price per unit increased significantly. The brewers and K-cups were the absolute core competencies of the company, they were essential in providing the distribution channels they had outsourced. 

Keurig’s major flaw throughout this entire case was outsourcing the designs for the K-Cup packing lines, and Brewers.  Any asset specific function which is absolutely essential to the firm’s survival should be done in house, if Keurig would have completed the designs in house they would not have been scrambling to find new suppliers who would have to reverse engineer everything.  They would not have had to rely on short term contracts as they did which ended up breaking down, and costing them large quantities of capital which could have been used much more efficiently.  High pressure situations would have been reduced, and they would not have had to rely on suppliers motives to be aligned with theirs. Without the designs they were left helpless with sharks in their swimming pool, if they decided to keep the designs in house they would have been able to stipulate terms on contract, liabilities, and aligned their pricing model with their business model.  By doing so they would have been able to assess the performance of the supplier, and choose to either extend contracts or terminate them, instead they were left with decisions to incur costs associated with their lack of knowledge concerning TCE.

In situations where reliance can be made entirely on the market mechanism the role of the entrepreneur is to coordinate resources that reduce uncertainty. Entrepreneurs recognize opportunities that exist and connect dispersed knowledge regarding products and demand to exploit a previously unrecognized opportunity.  The role of an entrepreneur is to provide an opportunity to an existing, or unrecognized demand in a way that benefits all parties involved. The reason that not all opportunities require a firm is because the market can be used as a much more efficient tool, the role of the entrepreneur in this case is to distinguish which tools to use in order to produce a product or service cheaper or faster by coordinating mutual knowledge of the marketplace.  The role of an entrepreneur is to seize opportunities and correct inefficiencies by coordinating resources around them. A true entrepreneur can create opportunities in the disequilibrium of the market with little or no capital required. My belief is that opportunities exist in front of us every day in the simplest form; it is up to us as the entrepreneur to allocate resources in a way that is creative and innovative and creates demand. Entrepreneurs must use carefully defined contracts in order to retain the rewards associated with contributions to their transactions.